Edited version of your private ruling

Authorisation Number: 1012516960959

Ruling

Subject: Division 7A

Question 1

Does subsection 109C(1) of the Income Tax Assessment Act 1936 (ITAA 1936) apply when the company makes a cash payment to you due to a Family Court Order under the Family Law Act 1975 (FLA)?

Answer

Yes

Question 2

Does section 109J of the ITAA 1936 apply when company makes a cash payment to you due to a Family Court Order under the FLA?

Answer

No

Question 3

Will the cash payment by the company to you be statutory income under subsection 6(1) of the ITAA 1936?

Answer

No

Question 4

Will the cash payment by the company to you be statutory income under subsection 44(1) of the ITAA 1936?

Answer

Yes

Question 5

Will the Commissioner apply the general anti-avoidance provision under Part IVA of the ITAA 1936 to the cash payment?

Answer

No

This ruling applies for the following periods:

1 July 2012 to 30 June 2013

1 July 2013 to 30 June 2014

The scheme commences on:

On or after 1 July 2013

Relevant facts and circumstances

You were married.

You are now separated.

You did not have a binding financial arrangement.

You and your spouse both propose to apply to the Family Court for orders to finalise a property settlement pursuant to the FLA.

The proposed consent orders are presently being drafted.

Subject to the Family Court's approval and following the resolution of this private binding ruling application, both will seek to have the following orders made by the Family Court under the FLA in satisfaction of the property settlement:

· That the company be made a party to the proceedings, and

· That the company pay to you a certain cash payment (or such other amount as the Family Court may order).

The directors of the company are you and your spouse. You are to resign as a director of the company.

All of the shares in the company are held by another taxpayer whom you are associated with.

You have never owned shares in the company.

Relevant legislative provisions

Subsection 109C(1) of the ITAA 1936

Section 109J of the ITAA 1936

Subsection 6(1) of the ITAA 1936

Subsection 44(1) of the ITAA 1936

Part IVA of the ITAA 1936

Reasons for decision

Question 1

Summary

Subsection 109C(1) of the ITAA 1936 will apply when the company makes a cash payment to you due to a Family Court Order under section 79 of the FLA.

Detailed reasoning

Subdivision B of Part III of Division 7A of the ITAA 1936 deals with the circumstances under which certain private company payments will be treated as dividends.

Under subsection 109C(1) of the ITAA 1936 where a private company pays an amount to an entity during the year, that payment is deemed to be a dividend where either:

(a) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder, or

(b) a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been such a shareholder or associate at some time.

Section 109ZD of the ITAA 1936 states that 'associate' has the meaning given by section 318.

In paragraph 109C(1)(a) of the ITAA 1936, you are an associate as a result of subsection 318(2).

Paragraph 109C(1)(b) of the ITAA 1936 would also be satisfied as you were an associate at some time.

As noted in Taxation Determination TD 2008/14, in the context of paragraph 109C(1)(b), 'because' means 'by reason that'. The reason must be a real and substantial reason for the payment even if it is not the only or main reason for the transaction.

At paragraphs 26 and 27, TD 2008/14 states:

… Given the breadth of paragraph 109C(1)(a), which as mentioned above requires no causal relationship between the making of the payment and the entity's status, the Commissioner considers it appropriate to take a broad view of the rule in paragraph 109C(1)(b) that is intended to support its operation. In particular, it would tend to make paragraph 109C(1)(b) ineffective if the existence of some other reason for a payment were enough to prevent the paragraph from applying. In other words, because paragraph 109C(1)(b) is there to stop people contriving ways to avoid paragraph 109C(1)(a), paragraph 109C(1)(b) in turn should be interpreted in a way that makes it relatively difficult to avoid, including by means of further contrivances.

In conclusion therefore, the existence of multiple reasons for a transaction does not prevent a reasonable person from concluding that the payment, loan or debt forgiveness occurred because the entity has been a shareholder or associate at some time.

For the purposes of paragraph 109C(1)(b) of the ITAA 1936, a reasonable person would conclude having regard to all the circumstances that the reason for the cash payment to you is the fact that you were previously an associate.

Therefore subsection 109C(1) of the ITAA 1936 would apply to the proposed cash payment to be paid by the company to you and be treated as a dividend.

Question 2

Summary

Section 109J of the ITAA 1936 does not prevent the payment from being treated as a dividend under subsection 109C(1) of the ITAA 1936.

Detailed reasoning

Section 109J of the ITAA 1936 provides that a private company is not taken under section 109C to pay a dividend because of the payment of an amount, to the extent that the payment:

(a) discharges an obligation of the private company to pay money to the entity; and

(b) is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm's length.

An order of the Family Court under section 79 of the FLA 1975 for a private company to pay money to an associate of a shareholder imposes a binding requirement in law for the payment to be made. This type of obligation is "an obligation of the private company to pay money to an entity" in terms of paragraph 109J(a) of the ITAA 1936.

However, both paragraphs 109J(a) and 109J(b) of the ITAA 1936 require satisfaction for the section to be enlivened so as to prevent a deemed dividend from arising under section 109C of the ITAA 1936.

Paragraph 109J(b) of the ITAA 1936 requires consideration of whether the payment made is more than would be required to discharge the obligation had the private company and shareholder (or their associate) been dealing at arm's length.

Paragraph 109J(b) of the ITAA 1936 therefore requires a testing of both the nature and extent of the underlying obligation as well as the payment. That is, a consideration of what would have been the payment had the parties been dealing with each other at arm's length necessarily involves an enquiry as to what would have been the obligation agreed between such parties.

The meaning of arm's length is well settled. In The Trustee for the Estate of the late AW Furse No 5 Will Trust v. FC of T , Hill J, in relation to the expression "not dealing with each other at arm's length" for the purposes of subsection 102AG(3) of the ITAA 1936, said:

"What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining."

Further, in Granby Pty Ltd v FC of T 95 ATC 4240; 30ATR 400, Lee J said in the context of the former paragraph 160ZH(9)(c) of the ITAA 1936 that the phrase 'at arm's length' means:

"at least, that the parties to a transaction have acted severally and independently in forming their bargain".

It follows that if the parties are acting severally and independently in forming their bargain that each must be bargaining in their respective best interests.

In the present context, the testing in paragraph 109J(b) of the ITAA 1936 is concerned with what pecuniary obligation would have arisen had the matrimonial parties and the private company been dealing with each other at arm's length. The arm's length requirement will thus require an alternate hypothesis in which the private company is engaged in a 'dealing' and pursuing its own best interests.

The alternative postulate takes us outside of a family law context. Firstly, the private company may only be subject to an order under section 79 of the FLA 1975 because it is not at arm's length to one or more of the matrimonial parties. Secondly, a matrimonial cause before the Family Court does not involve any 'dealing' or 'bargaining' between the parties to the proceedings. The Court must always exercise its own discretion on whether to make an order, and, if so what orders to make. This is so even if orders are sought by consent.

This is consistent with the extrinsic materials which make it clear that what was in contemplation is what would have arisen between the parties in a commercial setting. The Explanatory Memorandum expressly states:

An amount paid to discharge a pecuniary obligation owed by a private company to a shareholder or associate will not be treated as a dividend to the extent that the payment is not more than the amount the pecuniary obligation would have been if the private company and shareholder or associate had been dealing with each other at arm's length [new section 109J] . This section ensures that such commercial dealings are not unfairly taxed ……..

(emphasis added)

As a practical matter, the alternate hypothesis must proceed on the basis the private company is acting in accordance with law, whether that be in terms of its own governing constituent documents or the Corporations Act.

In terms of the Corporations Act, section 182 expressly prohibits officers or employees of a company from improperly using their position to gain an advantage for any other person or cause a detriment to the company.

In the present context the question which arises is whether a company would subject itself to an obligation to make a payment to a non-shareholder but for the Family Law context and if so, what would be the quantum of that obligation.

In terms of a dealing between a private company and a non-shareholder in a commercial setting, the private company may be incapable of making a payment representing the net assets of the company, being an appropriation of profits, directly to a non-shareholder. Such an appropriation may be in breach of sections 181 or 182 of the Corporations Act and/or in breach of the director's fiduciary duty not to misuse company funds. ¹

In a commercial setting, for a private company to make a payment to a non-shareholder, the payment would ordinarily need to be in consideration for something of value provided in return by the non-shareholder.

One possible circumstance in which a private company might make an appropriation of profits to a non-shareholder for nil consideration would be where the private company is empowered to make a gratuitous payment to the non-shareholder.

Even were a private company empowered to make a gratuitous payment, this is not of assistance in terms of the testing required by paragraph 109J(b) of the ITAA 1936. The essence of a gift is a voluntary appropriation of cash or property to a donee. A gift involves no imposition of any obligation on the donor nor any discharge of an obligation in the making of the gift (Federal Commissioner of Taxation v. McPhail (1968) 117 CLR 111 at 116; Leary v. FC of T 80 ATC 4438; 11 ATR 145 at 147)

A private company which makes a gratuitous payment to a non-shareholder is therefore not discharging any obligation in making the payment. A payment made in conformance with a Court order pursuant to section 79 of the FLA 1975 can therefore not be tested against a gratuitous payment for the purposes of paragraph 109J(b) of the ITAA 1936.

In view of the foregoing, the Commissioner considers there is no identifiable alternate hypothesis under which a private company might make an appropriation of profits to a non-shareholder in discharge of an obligation in an arm's length dealing as required by the testing in paragraph 109(b) of the ITAA 1936. Therefore, section 109J of the ITAA 1936 cannot apply to prevent a payment made in conformance with an order of the Family Court under section 79 of the FLA 1975 from being treated as a deemed dividend under section 109C of the ITAA 1936.

This conclusion also accords with the policy intent evident in paragraph 1.44 of the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 3) 2005 which inserted section 109RC of the ITAA 1936 which makes it clear such payments are intended to be assessable as dividends. The paragraph relevantly states:

"Under the current law, transfers of property and other 'payments' in respect of marriage or relationship breakdown are caught by Division 7A even though they may be non-voluntary (e.g. by court order)." [paragraph 1.44].

"The amendment provides that deemed dividends arising from 'payments' in respect of marriage or relationship breakdowns, may be frankable by the company ..." [paragraph 1.45].

"While these payments could be completely removed from being caught by Division 7A this would arguably be providing a tax benefit to these taxpayers which is not the intention of these provisions." [paragraph 1.99]."

Therefore, section 109J of the ITAA 1936 will not apply to your circumstances.

Question 3

Summary

The cash payment from the company to you will not be statutory income under subsection 6(1) of the ITAA 1936.

Detailed reasoning

Subsection 6(1) of the ITAA 1936 is not an assessing provision but defines terms used within the ITAA 1936. Therefore the question is whether the proposed payment falls within the definition of dividend in this subsection.

Section 995-1 of the ITAA 1997 provides that dividend has the meaning given by subsection 6(1) of the ITAA 1936.

Subsection 6(1) of the ITAA 1936 defines 'dividend' to include:

(a) any distribution made by a company to any of its shareholders, whether in money or other property; and

(b) any amount credited by a company to any of its shareholders as shareholders;

(c) (Repealed by No 63 of 1998)

but does not include:

(d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company; or

(e) moneys paid or credited, or property distributed, by a company for the redemption or cancellation of a redeemable preference share if:

(i) the company gives the holder of the share a notice when it redeems or cancels the share,

(ii) the notice specifies the amount paid-up on the share immediately before the cancellation or redemption, and

(iii) the amount is debited to the company's share capital account,

except to the extent that the amount of those moneys or the value of that property, as the case may be, is greater than the amount specified in the notice as the amount paid-up on the share; or

(f) a reversionary bonus on a life assurance policy.

Under subsection 6(1) of the ITAA 1936, a shareholder includes member or stockholder.

For a payment to be considered a dividend under this provision, the payment must be made by the company to a shareholder. The definition does not include associate or former associates of a shareholder. Therefore, the payment made by the private company to the shareholder's spouse, an associate or former associate of a shareholder would not be considered a dividend under subsection 6(1) of the ITAA 1936.

Based on the above, the cash payment would not come within the definition of the word 'dividend' in subsection 6(1) of the ITAA 1936.

Question 4

Summary

Section 109Z of the ITAA 1936 deems dividends taken to have been paid under Division 7A of the ITAA 1936 to have characteristics that fulfil the requirements of section 44 of the ITAA 1936.

Detailed reasoning

Subsection 6-10(2) of the ITAA 1997 provides that amounts that are not ordinary income, but are included in your assessable income by provisions about assessable income, are called statutory income.

Under subsection 44(1) of the ITAA 1936 the assessable income of a shareholder in a company who is a resident includes:

(a) dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source, and

(b) all non-share dividends paid to the shareholder by the company.

Section 109Z of the ITAA 1936 states that if a private company is taken under this Division to have paid a dividend to an entity, the dividend is taken for the purposes of this Act to be paid:

(a) to the entity as a shareholder in the private company; and

(b) out of the private company's profits.

The Explanatory Memorandum further explains that:

Paragraph 44(1)(a) includes in the assessable income of a shareholder in a company, 'dividends paid to him by the company out of profits derived by it from any source'. New section 109Z ensures that paragraph 44(1)(a) applies to amounts treated as dividends under new Division 7A, by taking the dividend to be paid to the shareholder or associate in the capacity of a shareholder, and out of the private company's profits.

Thus the amount of the cash payment is a deemed dividend for the purposes of Division 7A and will be statutory income under section 44 of the ITAA 1936.

Question 5

Summary

The Commissioner will not apply the general anti-avoidance provision under Part IVA of the ITAA 1936 to the cash payment from the company to you.

Detailed reasoning

Part IVA of the ITAA 1936 is a general anti-avoidance provision that can apply in certain circumstances. Part IVA gives the Commissioner the power to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

It must be noted from the outset that a private binding ruling only determines whether Part IVA applies. Specifically, a private binding ruling is not a Part IVA determination and cannot lead to the necessary action to give effect to the determination as required under subsection 177F(1) of the ITAA 1936.

In broad terms, Part IVA will apply where the following requirements are satisfied:

· there is a scheme (see section 177A of the ITAA 1936);

· a taxpayer has obtained, or would but for section 177F of the ITAA 1936 obtain, a tax benefit in connection with the scheme (see section 177C); and

· the dominant purpose of a person who entered into or carried out the scheme, or any part of the scheme, was to enable the relevant taxpayer to obtain a tax benefit in connection with the scheme, or to enable the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (paragraph 177D(b) of the ITAA 1936).

The application of Part IVA depends on a careful weighing of all the relevant facts and surrounding circumstances of each case.

Scheme

A scheme is defined in subsection 177A(1) of the ITAA 1936 as:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

The term 'scheme' is defined in very wide terms. It includes any agreement, arrangement, understanding, plan, proposal, action, course of action or course of conduct. As the definition of 'scheme' is drafted very widely, there will usually be little doubt that a scheme can be identified.

For the purposes of this application it is accepted that the proposed arrangement will constitute a scheme for the purposes of section 177A of the ITAA 1936.

Tax benefit

Under section 177C of the ITAA 1936 a tax benefit arises where an amount is not included in assessable income, where that amount would have been included, or might reasonably be expected to have been included, in assessable income if the scheme had not been entered into.

Paragraph 62 of Law Administration Practice Statement PS LA 2005/24: Application of General Anti-Avoidance Rules states:

Part IVA will not apply unless a taxpayer obtained, or would obtain, a tax benefit in connection with a scheme.

It can be seen that there is no tax benefit as a result of the proposed arrangement, as the income will be included as a dividend and would be declared as assessable income.

Conclusion

In your case, what you are proposing is a 'scheme' capable of attracting the operation of Part IVA. However, there would be no tax benefit as you will be required to declare the proposed dividend payment as assessable income in your income tax return. Therefore, Part IVA will not apply to this arrangement.

¹ The fiduciary duty is found in a different context in Paul A Davies (Aust) Pty Ltd v Davies (1983) 1 ACLC 1091.