Edited version of private advice

Authorisation Number: 1052227615407

Date of advice: 19 June 2024

Ruling

Subject: Commissioner's discretion - dividends deemed by division 7A

Question 1

Are the amounts of trust income appointed by the trustee for the XX XX Trust (the Trust)) to XX XX (Company) that are unpaid (Unpaid Present Entitlements or UPEs) a 'loan' for the purposes of subsection 109D of the Income Tax Assessment Act 1936 (ITAA 1936) and are treated as a payment of a dividend from Company to the Trustee?

Answer

Yes.

Question 2

Whether the Commissioner will make a decision that pursuant to paragraph 109RB(2)(a) of the ITAA 1936, each dividend is disregarded?

Answer

Yes, the Commissioner will exercise the discretion under section 109RB of the ITAA 1936 (to disregard the dividends deemed by Division 7A and dealt with in this private ruling) subject to the condition that for each of the periods for which this private ruling applies Company will be in the same position it would have been had it complied with Division 7A.

When calculating the payment amount to be made to Company, amounts representing interest accrued should be calculated using the relevant income year's benchmark interest rate (for the purposes of sections 109E and 109N of the ITAA 1936) and applying that to what the outstanding balance would have been at 30 June in the preceding income year, including any interest already accumulated for previous income years. This payment by the Trustee should be made before lodgment of Company's Company tax return 2023.

This ruling applies for the following periods:

Year ended XX XX XX to year ended XX XX XX

The scheme commenced on:

XX XX XX

Relevant facts and circumstances

1.       XX XX (XX or the Shareholder)is a tax resident of Australia. Shareholder currently resides in XX XX.

2.       Company was incorporated in Australia on XX XX XX.

3.       Shareholder is the sole director and shareholder of Company.

4.       XX XX (Company 2) is a company incorporated in Australia on XX XX XX. Shareholder is the beneficial owner of 100% of all the issued share capital and is the sole director of the company.

5.       Company 2 is the corporate trustee (the Trustee) of XX XX Trust, a discretionary trust settled by XX XX (TA), Shareholder's former tax agent, in early XX XX XX.

6.       Pursuant to the trust deed for the Trust, Shareholder and Beneficiary 2 are the primary beneficiaries, with Company being an additional member of the class of general beneficiaries (Clause X.X).

7.       References to Shareholder's 'associate entities' refers to the Trustee/Trust, the Company and Company 2 collectively.

8.       The Trust's assets consist primarily of XX and property situated at XX XX.

9.       The Trustee and Company accept that, as at 30 June of each year from XX XX XX to XX XX XX, Company had a distributable surplus (for the purpose of the definition of that term in section 109Y of the ITAA 1936) at least equal to the UPEs that are the subject of this application.

10.    The tax agent for the Shareholder (and associate entities), was tax agent since sometime before XX XX XX, until XX XX XX after lodgment of the XX XX XX income year returns. TA had been the family accountant for a number of years and had largely retired from public practice, only acting as tax agent for a select few clients as part of his transition to retirement (largely as an act of good faith due to the long-term existing relationship with the family).

11.    The Shareholder (and her associate entities) appointed XX XX (TA 2) to act as tax agent on or around XX XX XX.

Relevant transactions

Income year ending XX XX XX

12.    During the XX XX XX income year, the Trustee made Company presently entitled to trust income of $XX (A UPE).

13.    The closing balance of the UPEs at A year end was $XX XX.

Income year ending XX XX XX

14.    During the XX XX XX income year, the Trustee made Company presently entitled to trust income of $XX XX (XX XX XX UPE).

15.    During the XX XX XX income year, Company's tax liabilities of $XX XX were paid by the Trustee which as a result reduced the XX XX XX UPE accordingly.

16.    The closing balances of the UPEs at XX XX XX year end were as follows:

   XX XX XX UPE: $XX XX

   XX XX XX UPE: $XX XX

17.    During the XX XX XX income year, the Trustee made Company presently entitled to trust income of $XX XX (XX XX XX UPE).

18.    During the XX XX XX income year, Company's various annual and quarterly tax payments totalling $XX XX were paid by the Trustee. These amounts were credited to the outstanding UPEs.

19.    As a result, the A UPE was repaid in full before the lodgment (and lodgment due date) of the XX XX income tax return.

20.    The closing balances of the UPEs at XX XX XX year end were as follows:

•         XX XX XX UPE: $ XX XX

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE: $XX XX

Income year ending XX XX XX

21.    During the XX XX XX income year, the Trustee made Company presently entitled to trust income of $XX XX (XX XX XX UPE).

22.    During the XX XX XX income year, Company's various annual and quarterly tax payments totalling $XX XX were paid by the Trust. These amounts were credited to the outstanding XX XX XX UPE.

23.    The closing balances of the UPEs at XX XX XX -year end were as follows:

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE $XX XX

Income year ending XX XX XX

24.    During the XX XX XX income year, the Trustee made Company presently entitled to trust income of $XX XX (XX XX XX UPE).

25.    During the XX XX XX income year, Company's various annual and quarterly tax payments totalling $XX XX were paid by the Trust.

26.    The closing balances of the UPEs at 2021-year end were as follows:

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE $XX XX

•         XX XX XX UPE: $XX XX

Income year ending XX XX XX

27.    During the XX XX XX income year, the Trustee did not make Company presently entitled to any trust income.

28.    The closing balances of the UPEs at XX XX XX -year end were as follows:

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE $XX XX

•         XX XX XX UPE: $XX XX

•         XX XX XX UPE: $XX XX

29.    At XX XX XX, the Trustee had $XX XX owing to Shareholder which consisted of:

•         XX XX XX UPE balance of $XX XX

•         An interest free loan of $XX XX

Tax Refunds

30.    During the XX XX XX income year, Company received a tax refund of $XX XX, relating to the XX XX XX income year.

31.    During the XX XX XX income year, Company received a tax refund of $XX XX, relating to the XX XX XX income year.

32.    As Company did not have its own bank account at this time, the refunds were paid into the bank account of the Trust, thereby effectively creating loans between the Trustee and Company.

33.    During the XX XX XX income year, the Trustee paid Company's various annual and quarterly tax payments totalling $XX XX. This reduced the loan created from the XX XX XX refund to $XX XX XX.

34.    The net refund loan amounts are:

•         XX XX XX income year: $XX XX:

•         XX XX XX income year: $XX XX.

Preparation of Income Tax Returns

35.    The income tax returns for Shareholder and her associated entities for the years ended XX XX XX to XX XX XX have been prepared and lodged by TA. Shareholder provided all relevant documents to TA with respect to the relevant transactions set out below for the income years ending XX XX XX to XX XX XX as they relate to distributions from the Trustee to Company.

36.    In respect of the income tax returns lodged by TA on behalf of Company for the XX XX XX to XX XX XX income years, Label N at Question 8 did not disclose the existence of any loans to shareholders and their associates.

37.    TA 2 prepared the income tax return for Company for the XX XX XX income year. Label N at Question 8 disclosed loans to shareholders and their associates in the amount of $XX XX and was coded "A" - that all loans were made on or after XX XX XX.

38.    The XX XX XX income tax returns for Shareholder and her associate entities have not, as at the date of this application, been lodged.

39.    In accordance with the Commissioner's position in PS LA 2010/4, a UPE does not become financial accommodation until one year after the trust distribution which creates the present entitlement. The table below provides the amounts to which Company had been made presently entitled less repayments made to date:

Table 1: This table provides the amounts to which Company had been made presently entitled less repayments made to date.

Notes

1 Amounts Company had been made presently entitled to each income year.

2 Repayments made before the UPE would become a loan per the Commissioner's ruling.

3 The balance of each UPE at the time the Commissioner considers the entitlement converts to a Division 7A loan (being the earlier of the due date or lodgement of the income tax return).

4 Repayments made after UPE loan was converted to a loan.

5 The total outstanding amount at XX XX XX.

Circumstances surrounding the subject UPEs

40.    In respect of the creation of the aforementioned UPEs, these amounts remained outstanding for payment to Company from the Trust (i.e., Company never called for payment of the UPEs, and the balance of funds have remained accumulating in the Trust).

41.    The UPEs were reported as income in the tax return of the Company for each income year. The corporate tax payable on this income was funded by way of a transfer of funds from the Trust to the Company (thus reducing the total UPE balance for that income year).

42.    Income generated by the Trust was generally not withdrawn by Shareholder and/or used for personal purposes. Rather, most of it was reinvested in the Trust. Overall, the Trustee owes funds to Shareholder, rather than the Trustee lending funds to Shareholder - i.e. the Trustee did not distribute income and transfer those assets to Shareholder, rather Shareholder has been a net lender to the Trust.

Table 2: This table shows the Trustee owes funds to Shareholder (that is, the Trustee did not distribute income and transfer those assets to Shareholder, rather Shareholder has been a net lender of the Trust.

43.    You state that at the handover meetings between TA and TA 2, TA 2 requested copies of complying Division 7A loan agreements associated with the UPEs between Company and the Trust. The response from TA was to the effect of 'this is a UPE between a trust and private company, why would a complying loan agreement be required.' From this discussion, it is the belief of TA 2 that TA was unaware of the operation of the view of the Commissioner from XX XX XX onwards on the interaction between unpaid present entitlements and Division 7A. Specifically, TA was of the view that Division 7A did not apply to the relevant transactions as Division 7A applied to loans/distributions to shareholders and associates only and that the application of Division 7A did not extend to UPE arrangements.

44.    Shareholder does not have any formal tax training and does not have any awareness of Division 7A, nor of the specific operation of section 109D of the ITAA 1936 relying on TA for guidance as her tax adviser.

45.    On the basis that neither Shareholder nor TA were aware of the Commissioner's view of the arrangements, Company and the Trustee did not enter into a complying loan agreement when the UPE was first advanced or anytime thereafter.

46.    Other than the loans involving the UPE's there are no other Division 7A loans with any other members of the Shareholder's group. Company Pty Ltd has not provided any other loans or forms of financial accommodation to Shareholder or associated entities of Shareholder.

47.    TA prepared financial statements for the Trust for the abovementioned years. However, no financial statements were prepared for Company.

48.    The financial statements prepared by TA in relation to the Trust did not split each beneficiary's unpaid present entitlement, nor to which year the UPE related. The financial statements merely disclosed the total balance in a "Trade and other payables", described as "Beneficiary loans".

49.    Upon appointment, TA 2 reconstructed historical balance sheets based on the income tax returns lodged and what the Trust had paid in respect of Company's tax liabilities, to quantify the outstanding UPEs.

50.    Based on this reconstruction, the A income year distribution was repaid prior to the income becoming a Division 7A loan.

51.    There are no other Division 7A compliant loans set up by TA for other members of Shareholder's group. Specifically, Company has not provided any other loans or forms of financial accommodation to Shareholder or her associated entities, other than the UPEs.

Actions taken since becoming aware of the issue

52.    TA 2 became aware of the UPE issue following discussions with TA and commencing preparation of the Trust's income tax return for the year ended XX XX XX, which was lodged on or around XX XX XX. TA 2 has been unable to determine the exact date this became apparent; however, TA 2's recollection is that it became apparent shortly before the lodgment date of the Trust's XX XX XX income tax return.

53.    When the XX XX XX income tax return was prepared, it was decided that there was insufficient time to make a section 109RB of the ITAA 1936 application. Instead, the minimum repayment that would have been required if a complying Division 7A loan were in place was calculated and a dividend from Company equal to this amount was declared, offset against the UPE and distributed through the Trust to Shareholder.

54.    This calculation of the minimum repayment included a calculation of what the missed interest on a complying Division 7A loan agreement would have been if the agreement had been compliant having regard to the Commissioner's approach as set out in the now withdrawn ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements. This resulted in an additional $XX XX of interest income being included in Company's assessable income for the XX XX XX income year.

55.    This interest was treated as assessable for Company and was not treated as deductible for the Trust.

56.    After the lodgment of the XX XX XX income tax return:

a. Company opened a bank account in its own name in December XX XX XX

b. the outstanding UPE (at XX XX XX) made by the Trustee to the Company were paid in full (i.e., a total payment of $XX XX was paid by Trustee to Company) on XX XX XX, and

c. the total payment included an amount of interest that would have been calculated on the UPE balances, had a Division 7A complying loan agreement been in place.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 section 103A

Income Tax Assessment Act 1936 section 109C

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 subsection 109D(1)

Income Tax Assessment Act 1936 subsection 109C(3)

Income Tax Assessment Act 1936 paragraph 109D(3)(b)

Income Tax Assessment Act 1936 section 109E

Income Tax Assessment Act 1936 section 109J

Income Tax Assessment Act 1936 section 109K

Income Tax Assessment Act 1936 section 109L

Income Tax Assessment Act 1936 section 109M

Income Tax Assessment Act 1936 section 109N

Income Tax Assessment Act 1936 section 109NA

Income Tax Assessment Act 1936 section 109NB

Income Tax Assessment Act 1936 section 109Q

Income Tax Assessment Act 1936 section 109RA

Income Tax Assessment Act 1936 section 109RB

Income Tax Assessment Act 1936 subsection 109RB(2)

Income Tax Assessment Act 1936 subsection 109RB(3)

Income Tax Assessment Act 1936 section 109T

Income Tax Assessment Act 1936 subsection 109T(3)

Income Tax Assessment Act 1936 section 109ZD

Income Tax Assessment Act 1997 section 960-100

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

Yes. Division 7A will treat the UPEs as dividends. The UPEs are the provision of financial accommodation pursuant to paragraph 109D(3)(b) of the ITAA 1936 and are therefore loans to which subsection 109D(1) of the ITAA 1936 applies.

Detailed reasoning

Relevantly, Division 7A provides that a private company will be taken to pay an unfranked dividend in an income year if it makes a loan to a shareholder or their associate and the loan is not fully repaid before the private company's lodgment day (paragraph 109D(1)(b) of the ITAA 1936), and not excluded by Subdivision D (paragraph 109D(1)(c) of the ITAA 1936).

There are also rules in Subdivision E of the ITAA 1936 which treat transactions made by interposed entities as having been made directly by the private company. Subdivision D of the ITAA 1936 has exceptions where Division 7A won't apply.

For the purposes of Division 7A of the ITAA 1936 section 109ZD of the ITAA 1936 provides:

•         'associate' has the meaning given by section 318 of the ITAA 1936, and

•         'entity' has the meaning given by section 960-100 of the ITAA 1997.

Associates of entities include the trustee of any trust where the entity benefits under the trust: paragraph 318(1)(d) of the ITAA 1936.

Section 960-100 of the ITAA 1997 provides that 'entity' includes individuals, bodies corporate, partnerships, and trusts for the purposes of both tax acts.

Broadly, 'private company' is an incorporated company which is not public:

•         Section 6 of the ITAA 1936 provides that a 'private company' means a company that's a private company for the purposes of Division 7 of the ITAA 1936. Section 6 provides that 'company' takes its meaning from section 995-1 of the ITAA 1997.

•         Section 995-1 of the ITAA 1997 states that a 'company' includes a body corporate. 'Body corporate' is not defined in either tax Act, but it means an artificial entity with a separate legal existence, and includes entities created under the Corporations Act (see MT 2006/1).

•         The effect of section 103A of the ITAA 1936 (in Division 7) is that private companies are companies which are not public companies. Public company loosely means companies which have shares listed on a stock exchange or fall within a short list of other company types (they include government-controlled companies, non-profits, and cooperatives or similar bodies).

In this instance:

•         Company is a private company:

o   it is incorporated as a proprietary company under Australian law

o   it is family controlled, and

o   it is not listed on the stock exchange, or a non-profit.

•         Shareholder and the Trustee/Trust are all 'entities' for tax purposes - they are either an individual, or a trust.

•         The Trustee/Trust is an associate of Shareholder as Shareholder benefits under Trust

•         Company is a private company; the Trustee/Trust is an 'associate' of Company's shareholder.

Relevantly, loans from private companies to shareholders or associates may be treated as deemed dividends. Section 109D of the ITAA 1936 applies if 3 core elements are met.:

•         First, either the loan recipient is a shareholder (or an associate of a shareholder) when the loan is made, or a reasonable person would conclude the loan was made because the entity was a shareholder (or an associate) at some time.

•         Second, the loan is not fully repaid by the lodgment date for the income year.

•         Third, an exception in Subdivision D does not apply.

The term 'Loan' for Division 7A of the ITAA 1936 purposes has an extended meaning. Subsection 109D(3) of the ITAA 1936 provides that for the purposes of Division 7A, a loan includes:

(a)       an advance of money; and

(b)       a provision of credit or any other form of financial accommodation; and

(c)       a payment of an amount for, on account of, on behalf of or at the request of, an entity if there is an express or implied obligation to repay the amount; and

(d)       a transaction (whatever its terms or form) which in substance effects a loan of money.

The Commissioner's principles for interpreting the phrase 'any other form of financial accommodation' are set out in Taxation Determination TD 2022/11 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of 'financial accommodation'?.

The phrase 'any other form of financial accommodation' is not defined for the purposes of Division 7A. It therefore has its ordinary and legal meaning in the statutory context in which it appears. The following principles for interpreting this phrase can be drawn from relevant case law:

•         any other form of financial accommodation is to be construed broadly

•         there must be a consensual arrangement between the parties

•         failure to call for payment of a UPE constitutes a benefit to the trustee.

The Commissioner takes the view that a private company beneficiary that does not exercise its right to demand immediate payment of an amount of trust income provides financial accommodation to the trustee. If the private company beneficiary exercised its right, the trustee would be required to arrange funds for the payment of the UPE, whether by selling or borrowing against other assets which would then no longer be available.

Relevantly, for financial accommodation to be provided, there must be a consensual arrangement between the parties. A consensual arrangement can only arise where a private company beneficiary has a UPE and has knowledge of an amount of trust income that it can demand immediate payment of from the trustee. Where both the trustee and the private company beneficiary are controlled by the same person, knowledge of an amount of trust income may be imputed by virtue of the relationship.

The doctrine of a corporation's 'directing mind and will' was explained by Millet J in El Ajou v. Dollar Land Holdings plc and another (referred to with approval on appeal) as follows:

Since a company is an artificial person, the knowledge of those who manage and control it must be treated as the knowledge of the company.... Those who 'constitute the directing mind and will of the company' are the company for this purpose. Their minds are its mind; their intention its intention; their knowledge its knowledge.

In circumstances where a number of entities share a common controller, the controller's knowledge of one of the group's affairs can generally be attributed to another member of the same group. In Endresz v. Whitehouse Ormiston JA referred to 'the principle applicable to controlling directors'. He quoted from Ford's Principles of Corporations Law as follows:

A distinction has to be drawn between the case where the director is a controller of two companies and where the director is only one of several directors of two companies. In the former case each company will know what the other knows because they each have the same directing mind and will: attribution of the director's knowledge to each company does not depend on the existence of a duty but on the director being identified with each company as its directing mind and will.

The directing mind and will of a private company need not be limited to its board or one or more directors. Case law establishes that different persons may for different purposes satisfy the requirements of being an entity's directing mind and will.

Where a UPE remains outstanding, and the private company beneficiary and the trustee have the same directing mind and will, the private company beneficiary will have knowledge of the amount of trust income that it can demand immediate payment of from the trustee. By not exercising its right to demand payment of the UPE, the private company beneficiary consents or acquiesces to the provision of financial accommodation to the trustee.

Subsection 109D(4) of the ITAA 1936 states that a loan is made to an entity at the time anything described in subsection 109D(3) of the ITAA 1936 is done in relation to the entity.

For the purposes of paragraph 109D(3)(b) of the ITAA 1936, a private company beneficiary makes a loan to the trustee of a trust, or another shareholder or their associate, when financial accommodation is provided.

Where there is a UPE, financial accommodation is provided at the point in time when the private company beneficiary has knowledge of an amount of trust income that it can demand immediate payment of from the trustee and does not exercise its right.

The time when the amount of a beneficiary's entitlement is known will typically arise after the end of the income year, in the following income year. This will be the case whether the entitlement is expressed as:

•         a fixed amount from the trust income

•         a percentage of trust income, or some other part of trust income identified in a calculable manner, or

•         a combination of fixed and calculable amounts.

Generally, the distributable income of a trust estate for an income year is only capable of being determined with sufficient certainty to quantify the amount of the entitlement when accounts are finalised. This will usually be after the income year has ended.

In addition to having knowledge of an amount of trust income that it can demand immediate payment of, the provision of financial accommodation by the private company beneficiary also requires that there is a deliberate choice or acquiescence as to the exercise of that right. In order to make a decision not to call for satisfaction of a UPE, the private company needs a reasonable opportunity to do so. So, for example, where a private company's UPE is determined on the last day of the income year in which it is conferred, the earliest time at which it is reasonable for a private company to call for that UPE to be satisfied will be in the following income year.

There may be limited circumstances in which a private company's present entitlement is known before the end of the income year in which it arises and it could have demanded payment of that amount. This will depend on the terms of the trust deed, the entitlement conferred by the trust resolution and the nature of the income derived and expenses incurred by the trust. A situation where the amount to be demanded is known with sufficient certainty might arise if a trust ceases mid-year or otherwise ceases operations and distributes income in the course of doing so.

There are rules in Subdivision D of the ITAA 1936 that prevent transactions which are on arm's length terms or are already assessable from being treated as dividends. Briefly the circumstances where provisions in Subdivision D of the ITAA 1936 exclude transactions from Division 7A are:

•         Payments that discharge arm's length obligations: section 109J of the ITAA 1936.

•         Payments and loans between companies: section 109K of the ITAA 1936.

•         Payments and loans that are already assessed as income or are excluded from assessable income under a specific provision: section 109L of the ITAA 1936.

•         Loans made in the ordinary course of business on arm's length terms: section 109M of the ITAA 1936.

•         Transactions made as or converted into qualifying written loan agreements requiring repayment on specified terms that comply with section 109N of the ITAA 1936.

•         Liquidator's distributions: section 109NA of the ITAA 1936.

•         Loans to purchase shares under an employee share scheme: section 109NB of the ITAA 1936.

•         Demerger dividends: section 109RA of the ITAA 1936.

•         Transactions where the Commissioner applies a discretion to vary how Division 7A operates. Section 109RB of the ITAA 1936 allows the Commissioner to disregard dividends or allow them to be franked if Division 7A because of an honest mistake or inadvertent omission. Section 109Q of the ITAA 1936 allows the Commissioner to disregard dividends caused from a failure to make the required minimum yearly repayment under section 109E of the ITAA 1936 (where satisfied that the dividend would cause hardship and was triggered by circumstances outside the entity's control).

Within private groups, it is common practice for trustees to appoint trust income to a related private company beneficiary. The appointed trust income is included in the profits of the corporate beneficiary. The company is assessed on its share of the trust's net income under the rules in Division 6.

Conclusion

In this case Company was made presently entitled to Trust income and that entitlement is not satisfied and consequently there were UPE's for each of the respective income years.

As Company had UPEs that by arrangement, understanding or acquiescence, it consented to the Trustee retaining those amounts, and to continue using them for Trust purposes and had knowledge that it could demand immediate payment of those amounts from the Trustee, and had not demand payment, the arrangement constituted the provision of financial accommodation to the trustee under paragraph 109D(3)(b) of the ITAA 1936. As a result, Company made loans to the Trustee under the extended definition of a 'loan' in subsection 109D(3) of the ITAA 1936.

Company made the loans when the financial accommodation was provided. These loans occurred at the point in time when Company had knowledge of the amount that it could demand immediate payment of from the Trustee and did not demand payment of the amount.

As Company and the Trustee had the same directing mind and will, Company was taken to have knowledge of the amount that it could have demanded immediate payment of from the Trustee when the Trustee did in the following income year.

Division 7A therefore would treat Company as having paid dividends to Trust unless an exception applies.

The excluding rules in Subdivision D won't apply unless the Commissioner exercises a discretion to vary how Division 7A operates. Most of those rules aren't relevant to this scenario as follows:

•         Company has not discharged an arm's length obligation; it did not set-off its entitlement against an obligation or debt it owed to the Trust.

•         There are no transactions between Company and another company.

•         The Trustee did not include Company's payment as an amount in its assessable income.

•         Company's loan is not an arm's length loan made in the ordinary course of business. It does not carry on any business (such as a money lending business).

•         The entities did not enter loan agreements that complied with section 109N of the ITAA 1936.

•         The rules about liquidation, employee share schemes, and demergers are not relevant.

•         The Commissioner's discretion under section 109Q of the ITAA 1936 is not relevant here because the parties have not entered loan agreements that comply with section 109N of the ITAA 1936.

•         Section 109RB of the ITAA 1936 may be relevant where Division 7A applies.

It follows that the operative rules in Division 7A apply to the UPEs (loans) from Company to the Trustee. Company is a private company. Company is treated as having made loans to Trustee. The Trustee/Trust is an associate of Company's shareholders. The elements of section 109D of the ITAA 1936 are met. The excluding rules in Subdivision D will not apply unless the Commissioner applies the discretion in section 109RB of the ITAA 1936.

Question 2

Summary

The Commissioner will exercise the discretion under section 109RB of the ITAA 1936 (to disregard the dividends deemed by Division 7A and dealt with in this private ruling) subject to the condition that for each of the periods for which this private ruling applies Company will be in the same position it would have been had it complied with Division 7A.

When calculating the payment amount to be made to Company, amounts representing interest accrued should be calculated using the relevant income year's benchmark interest rate (for the purposes of sections 109E and 109N of the ITAA 1936) and applying that to what the outstanding balance would have been at 30 June in the preceding income year, including any interest already accumulated for previous income years. This payment by the Trustee should be made before lodgment of Company's XX XX XX income tax return.

Detailed reasoning

Section 109RB of the ITAA 1936 empowers the Commissioner to disregard the operation of Division 7A where the deemed dividend arises out of an honest mistake or inadvertent omission. Subsection 109RB(1) of the ITAA 1936 sets threshold conditions:

•         First, Division 7A must operate to treat an amount as a dividend.

•         Second, that result must have arisen because of an honest mistake or inadvertent omission by the recipient, the private company, or any other entity whose conduct contributed to that result.

Where those circumstances are met, subsection 109RB(2) of the ITAA 1936 provides that the Commissioner may make a decision to disregard a deemed dividend, or allow it to be franked.

Subsection 109RB(3) of the ITAA 1936 lists relevant considerations for determining that decision. They include:

•         the circumstances leading to the mistake or omission

•         the extent any entities have tried to correct it, and if so, how quickly

•         whether Division 7A has applied before

•         any other matters the Commissioner considers relevant.

The Commissioner is unable consider exercising the discretion where a mistake or omission did not cause Division 7A to operate. In other words, the mistake or omission must have triggered Division 7A for the discretion to be available (see Taxation Ruling TR 2010/8 Income tax: application of subsection 109RB(1) of the Income Tax Assessment Act 1936 at paragraphs 47 through 52 and Practice Statement Law Administration 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).

PSLA 2011/29 provides a 2 step process for deciding whether to exercise the discretion. Step 1 instructions are about helping determine whether Division 7A was triggered by an honest mistake or inadvertent omission. Step 2 instructions are about deciding whether the Commissioner's discretion should be exercised, and if so, how and under what conditions.

Applying this two-step approach to these facts.

Step 1: Division 7A applied because of Shareholder and TA's mistake or omission about the tax consequences of the transactions.

Under Step 1, Practice Statement Law Administration 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 suggests some considerations that are relevant to determining whether a mistake or omission is honest or inadvertent.

Step 1 non exhaustive considerations in PS LA 2011/29

Table 3: This Table shows the non-exhaustive considerations in PS LA 2011/29

While some circumstances may suggest otherwise, on balance, Division 7A applied to the relevant transactions because of an honest mistake or inadvertent omission.

•         Shareholder and Company reasonably relied on their former tax agent's advice as they are not tax professionals. However, as the tax agent was not aware of the implications of Division 7A in these particular circumstances Shareholder and Company were also unaware of its application in this case. While TA, as a tax agend, ought to have know that the UPEs were subject to Division 7A, this on its own does not mean that there was not an honest mistake or inadvertent omission

•         the law about how Division 7A applies where a trust does not pay present entitlements to a private company beneficiary isn't straightforward.

•         There are no other Division 7A loans to other group members.

•         In this case the shareholders didn't have use of the funds as Shareholder was lending money to the Trust.

•         There is no evidence to suggest that the failure to apply Division 7A was not an honest mistake or inadvertent omission.

Step 2: The Commissioner should only exercise the discretion if the relevant entities pay Company all Division 7A amounts, plus appropriate interest, including amounts where the amendment period has expired.

Under Step 2, PS LA 2011/29 the considerations referred to in the table above are also relevant to the decision about whether to exercise the discretion to disregard a dividend (or allow dividends to be franked).

Other considerations include the extent of any corrective action taken or proposed by the relevant entities.

The result of exercising the discretion should restore retained profits to the private company, achieve the correct repayments covering both principal and interest, and ensure the recipient of the loan, payment, or forgiveness is appropriately taxed.

Period of review is also a relevant consideration.

The Commissioner may make the decision to exercise a discretion subject to conditions, such as making specified payments, or specified requirements in Division 7A, by specified times.

In this case the discretion will only be exercised to disregard dividends if the relevant parties restore Company, as closely as possible, to the position it would have been had Division 7A been complied with from the beginning.

To comply with Division 7A, the Trust would have had to pay that money, either by lodgment day, or by entering into a loan agreement requiring it to make payments including interest.

Had Division 7A been complied with from the beginning, all relevant transactions would have been paid (with interest if not repaid by the relevant lodgment day).

The Trust did not pay the distribution amounts or enter into complying loan agreements under section 109N of the ITAA 1936. Most section 109N loan agreements are unsecured 7-year loans rather than secured 25-year loans.

This means the Trust has had the benefit of accessing funds sourced from Company's entitlements over a number of years, without paying tax, repaying the funds, or paying interest on that money.

To approximately return Company to a Division 7A compliant position, the Trust will need to pay all Division 7A amounts, plus appropriate interest.

Under this concessionary approach, transactions for periods where the amendment period has expired are not excluded from the necessary corrective action, on the basis that the discretion in section 109RB of the ITAA 1936 should not be exercised in a way:

•         which would make a taxpayer better off than others who had complied with Division 7A: if other taxpayers in this position had complied with Division 7A from the beginning, they would have had to repay all transactions with necessary interest payments.

•         which puts taxpayers in a better position than if they had fully complied, or leaves a private company in a worse position, just because amendment periods have expired: disregarding dividends without requiring full repayment and appropriate interest would have that effect.

In this case, to the extent that the UPE amounts have been paid it is not necessary to convert the transactions into section 109N complying loan agreements.

On balance, the Commissioner considers that it will be reasonable to exercise the discretion in 109RB of the ITAA 1936:

•         The Company acted in accordance with the registered tax agent's instruction. The Shareholder and Company had sought professional assistance in meeting their tax obligations - including providing all relevant documents to the former tax agent.

•         The tax agent was ignorant of the application of Division 7A to unpaid present entitlements to private companies. There is no evidence to suggest that the entities deliberately took steps to circumvent Division 7A.

•         The shareholder has not directly benefited from the unpaid present entitlements. The Shareholder had made loans to the trust which are generally in excess of the UPEs.

•         But for the voluntary disclosure, the Commissioner may have remained unaware of the issue.

•         Upon TA 2's discovery of the error made by the previous tax agent the Taxpayers have acted promptly to remedy the mistake.

The Commissioner will exercise the discretion under section 109RB of the ITAA 1936 (to disregard the dividends deemed by Division 7A and dealt with in this private ruling) subject to the condition that for each of the periods for which this private ruling applies Company will be in the same position it would have been had it complied with Division 7A.

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