Edited version of your private ruling

Authorisation Number: 1012539903516

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Ruling

Subject: Division 7A - marriage breakdown and Family Law Court orders

Questions and Answers

1. Does section 109J of the ITAA 1936 apply to a Family Court order under section 79 of the Family Law Act 1975 (FLA 1975) that directs a company to transfer an amount in cash to taxpayer 2?

No.

2. Will taxpayer 2 be taken to have received a deemed dividend pursuant to section 109C of the Income Tax Assessment Act 1936 in respect of the payment by the company to taxpayer 2 of cash, pursuant to Family Court orders under section 79 of the FLA 1975?

Yes.

3. Will this cash payment to taxpayer 2 be a dividend for the purposes of subsection 6(1) of the Income Tax Assessment Act 1936?

Yes.

4. Will this cash payment to taxpayer 2 be statutory income under subsection 44(1) of the Income Tax Assessment Act 1936?

Yes.

This ruling applies for the following period

1 July 2013 to 30 June 2014

Relevant facts and circumstances

Taxpayer 1 and taxpayer 2 separated.

Some time later taxpayer 1 and taxpayer 2 were divorced.

Taxpayer 1 and taxpayer 2 commenced Family Law Court proceedings in relation to their financial matters which have been marked as complex.

Their proceedings have been managed by a judge.

The proceedings were listed for trial in the Family Court, however judgement has been reserved.

Taxpayer 1 and taxpayer 2 each own one share in the company.

Subject to the Family Court's approval, taxpayer 1 and taxpayer 2 will seek the following order to be made by the Family Law Court under the Family Law Act as part of the divorce settlement;

- The company is to become party to the dispute, as Second Respondent;

- Taxpayer 2 is to transfer their share in the company to taxpayer 1; and

- The company is to pay the sum of an amount to taxpayer 2 after the share is transferred.

The court order will be binding on all parties, including the company.

The company currently has a distributable surplus.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 subsection 44(1)

Income Tax Assessment Act 1936 Section 109C

Income Tax Assessment Act 1936 Section 109D

Income Tax Assessment Act 1936 subsection 109D(4A)

Income Tax Assessment Act 1936 Section 109J

Income Tax Assessment Act 1936 Section 109L

Income Tax Assessment Act 1936 Section 109Z

Income Tax Assessment Act 1997 subsection 6-10(2)

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not considered the application of Part IVA to the arrangement you asked us to rule on.

Reasons for decision

Question 1

Summary

Where an order is made against under section 79 of the Family Law Act 1975 (FLA 1975) and that order requires a private company to make a payment to a party to the matrimonial proceedings who is an associate of a shareholder of the private company, the subsequent payment in conformance with the order is a payment for the purposes of paragraph 109C(3)(a) of the Income Tax Assessment Act 1936 (ITAA 1936).

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 Subdivision D of Division 7A reads as follows:

109J PAYMENTS DISCHARGING PECUNIARY OBLIGATIONS NOT TREATED AS DIVIDENDS

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. [The Family Law Act 1975 enables the court to impose sanctions on parties to property settlements who fail to comply with orders made. The sanctions include under section 112AD of the FLA 1975: .a bond (for up to 2 years); a sentence (not more than 12 months) or a fine (not more than $6,600)]. 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 (as paragraph 109J(b) directs us to do), 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 91 ATC 4007;, 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.[see Harris v Caladine (1991) 172 CLR 84 at 96, 103-104, 124, 133]

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 2001.

In terms of the Corporations Act 2001, 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 This is a statutory duty to act in good faith and for a proper purpose or 182 of the Corporations Act 2001 and/or in breach of the director's fiduciary duty not to misuse company funds. [The fiduciary duty is found in a different context in Paul A Davies (Aust) Pty Ltd v Davies (1983) 1 ACLC 1091].

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. [A private company may be empowered to confer a financial benefit on a related party if full disclosure is given and approval is obtained from shareholders in the manner prescribed in Chapter 2E of the Corporations Act].

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 or any discharge of an obligation in the making of the gift.[see 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 109J(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 [Section 109RC provides that a deemed dividend that is taken to be paid because of a family law obligation may be franked. 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]."

Question 2

Summary

Section 109C of the ITAA 1936 will apply when the company makes a cash payment, pursuant to a Family Court order under section 79 of the FLA 1975, to taxpayer 2.

Detailed reasoning

Division 7A of Part III of the ITAA 1936 is directed at ensuring that disguised or informal distributions of private company profits to shareholders or their associates are included in the assessable income of the shareholder or associate [See for example, para 1.4 of the Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 2) Bill 2010].

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 of the ITAA 1936. Section 318 includes a relative as an associate. A relative includes a spouse (subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997).

Thus paragraph 109C(1)(a) of the ITAA 1936 will be satisfied at the time of the payment if taxpayer 2 is still the spouse of the shareholder, taxpayer 1.

If taxpayer 2 is no longer the spouse of taxpayer 2 at the time of the payment paragraph 109C(1)(b) of the ITAA 1936 applies. Taxpayer 2 has been an associate of a shareholder, taxpayer 1, at some time.

Under paragraph 109C(1)(b), Division 7A may also operate to deem a dividend where the payment or transfer of property is made to an entity that is a former shareholder or former associate of a shareholder. The paragraph operates where a reasonable person would conclude that the payment or transfer of property was made 'because' the recipient entity is a former shareholder or former associate of a shareholder. The Commissioner's view on the meaning of 'because' in context is contained in Taxation Determination TD 2008/14. [Income tax: Division 7A of Part III of the Income Tax Assessment Act 1936 - what is the meaning of 'because' in the context of the expression 'because the entity has been such a shareholder or associate at some time' in relation to payments, loans and debt forgiveness made by a private company to the entity?]. Paragraph 1 of TD 2008/14 relevantly states:

1. In this context 'because' means by reason that. The reason must be a real and substantial reason for the payment, loan or debt forgiveness concerned, even if it is not the only reason or not the main reason for the transaction.

In the family law context, where the matrimonial parties are already divorced, the very reason why the section 79 order is available to the Court is that a matrimonial cause is available by virtue of the recipient's status as a former spouse. Therefore, the "real and substantial" reason for the payment or transfer of property (as contemplated in TD 2008/14) is the recipient's status as a former associate of a shareholder. [Under the paragraph (ca) meaning of matrimonial cause in subsection 4(1) of the FLA 1975, such causes include proceedings between the parties to a marriage with respect to the property of the parties to the marriage or either of them, being proceedings: (i) arising out of the marital relationship; (ii) in relation to concurrent, pending or completed divorce or validity of marriage proceedings between those parties……]

The temporal question of whether at the time a payment or transfer of property is made, the recipient is still an associate of a shareholder does therefore not impact upon the operation of Division 7A.

A reasonable person would conclude that the reason for the cash payment to taxpayer 2 is the fact that they were previously an associate of a shareholder, taxpayer 1.

The explanation which follows only refers to associates but the reasoning is equally applicable to former associates.

Subsection 109C(3) defines a payment to mean:

(a) a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and

(b) a credit of an amount to the extent that it is:

(i) to the entity; or

(ii) on behalf of the entity; or

(iii) for the benefit of the entity; and

(c) a transfer of property to the entity.

Where the positive tests of section 109C of the ITAA 1936 are satisfied, the payment by the company to taxpayer 2 will be treated as a dividend unless an exclusion contained in Subdivision D of Division 7A applies.

Subsection 109C(2) of the ITAA 1936 provides that the dividend is taken to equal the amount paid, subject to section 109Y of the ITAA 1936. As the sum of all the dividends the company is taken under Division 7A of the ITAA 1936 to have paid at the end of the year of income for the year of income in which the cash, property and motor vehicle is transferred, will not be more than the company's distributable surplus for that year the dividend will be the amount paid.

Subsection 109C(3) of the ITAA 1936 provides that a payment to an entity means a payment to the extent that it is to the entity. The payment of the cash to taxpayer 2 is a payment to them and meets the requirements of subsection 109C(3).

Subsection 109C(3A) of the ITAA 1936 provides that a loan to an entity is not a payment to the entity. As the payment of cash to taxpayer 2 is not a loan subsection 109C(4) of the ITAA 1936 does not operate to exclude the payment from the operation of 109C of the ITAA 1936.

Therefore section 109C of the ITAA 1936 applies in respect of the payment by the company to taxpayer 2.

Question 3

Summary

Although taxpayer 2 is not a shareholder at the time of payment, section 109C of the ITAA 1936 provides that the company is taken to pay a dividend to taxpayer 2.

Detailed reasoning

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.

As discussed in the detailed reasoning for question 2 above the requirements of subsection 109C(1) of the ITAA 1936 will be met and thus the payment is deemed to be a dividend.

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(1) 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.

Subsection 44(1) of the ITAA 1936 provides that the assessable income of a resident shareholder in a company includes dividends that are paid to the shareholder out of profits derived by the company from any source.

Section 109Z of the ITAA 1936 provides that the dividend a private company is taken under Division 7A of the ITAA 1936 to have been paid to an entity is taken for the purposes of the ITAA 1997 and the ITAA 1936 to be paid;

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

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

As the sum of all the dividends the company will be taken under Division 7A of the ITAA 1936 to have paid at the end of the relevant year of income will not exceed its distributable surplus for that year, subsection 109Y of the ITAA 1936 does not apply to adjust the amount of the dividend the company is taken under Division 7A of the ITAA 1936 to have paid.

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(1) of the ITAA 1936.