Edited version of your written advice

Authorisation Number: 1013046747874

Date of advice: 7 July 2016

Ruling

Subject: Deemed dividends, commercial debt forgiveness and loan fringe benefits

Question 1

If CompanyA provides loans to the Associates to enable them to exercise options acquired under an employee share scheme, will these loans be exempt from Division 7A as a result of the operation of section 109NB of the Income Tax Assessment Act 1936 (Cth) ('ITAA 1936')?

Answer

No

Question 2

Will the loans satisfy section 109N of the ITAA 1936, thereby exempting the loans from being regarded as a dividend pursuant to Division 7A of the ITAA 1936?

Answer

Yes

Question 3

Will the debt forgiveness rules contained in Division 245 of the Income Tax Assessment Act 1997 (Cth) ('ITAA 1997') have any practical application to any forgiveness of the loans that may occur?

Answer

No

Question 4

Will the employer, CompanyA, be required to pay fringe benefits tax ('FBT') pursuant to the Fringe Benefits Tax Assessment Act 1986 (Cth) ('FBTAA') upon provision of the loans to the Associates?

Answer

No

This ruling applies for the following periods:

For the income years ending 30 June 2016 to 30 July 2019

The scheme commences on:

During the income year ending 30 June 2015

Relevant facts and circumstances

CompanyA is a company registered in Australia and is an Australian resident for tax purposes. CompanyA is not listed on any stock exchange.

Certain associates of key employees within CompanyA ('Associates') were provided options to acquire a beneficial interest in shares in CompanyA. The options were provided in connection with an employee share scheme.

CompanyA proposes to provide the Associates limited recourse loans in order for them to exercise their options and acquire shares in CompanyA. The loan term is for 7 years with an interest rate payable at X% per annum. The loans will be repayable at the expiration of the loan term or when the Associate ceases to be an employee of CompanyA. The loan agreement containing the terms of the loan is in writing.

If the Associates are unable to repay the loans when they become due, CompanyA will acquire the Associates' shares in CompanyA:

• for the value of the loans, if the value of the shares is not less than the exercise price; or

• for the market value of the shares, if the value of the shares have depreciated in price below the exercise price.

The exercise price is equal to the value of the loans provided by CompanyA.

The loan will be used by the Associates to acquire shares in CompanyA. CompanyA expects to pay out dividends on its shares in the future. The applicant has advised that the Associates would be able to claim an income tax deduction for any interest payable on the loan.

The Associates are currently shareholders or associates of shareholders of CompanyA.

Relevant legislative provisions

Fringe Benefits Tax Assessment Act 1986

Subsection 136(1)

paragraph 136(1)(s)

Income Tax Assessment Act 1936

Division 7A

section 109D

subsection 109D(1)

section 109N

section 109N(1)

paragraph 109N(3)(b)

section 109NB

Income Tax Assessment Act 1997

subsection 83A-10(1)

Subdivision 83A-B

subsection 83A-20(1)

subsection 83A-20(2)

Subdivision 83A-C

subsection 83A-105(1)

Division 245

paragraph 245-10(a)

Subdivisions 245-C

paragraph 245-35(a)

section 245-55

section 245-60

subsection 245-60(1)

subsection 245-60(2)

section 245-65

subsection 245-65(1)

section 245-75

subsection 245-75(2)

Reasons for decision

Question 1

Summary

Section 109NB of the Income Tax Assessment Act 1936 (Cth) ('ITAA 1936') will not apply as the loan is not provided for the purpose of enabling the Associate to acquire an employee share scheme interest under an employee share scheme to which Subdivision 83A-B or Subdivision 83A-C of the Income Tax Assessment Act 1997 (Cth) ('ITAA 1997') applies.

Detailed reasoning

Division 7A of the ITAA 1936 deals with the circumstances under which certain distributions made by a private company in the form of payments, loans or forgiven debts will be treated as dividends.

Subsection 109D(1) of the ITAA 1936 states that a private company is taken to pay a dividend to an entity if:

(a) the private company makes a loan to the entity during the current year, and

(b) the loan is not fully repaid before the lodgement day for the current year, and

(c) none of the exceptions in Subdivision D apply, and

(d) either:

(i) the entity is a shareholder or an associate of the shareholder in the company when the loan is made; or

(ii) a reasonable person would conclude that the loan is made because the entity has been a shareholder or associate at some time.

The loans provided to the Associates by CompanyA could satisfy subsection 109D(1) of the ITAA 1936 if the Associates do not fully repay the loan before the lodgement day in the income year in which the loan is made and none of the exceptions in Subdivision D of the ITAA 1936 apply.

Subdivision D of the ITAA 1936 details certain loans that are not treated as dividends, and thus are excluded from the operation of section 109D of the ITAA 1936. Section 109NB in Subdivision D of the ITAA 1936 provides that:

A private company is not taken under section 109D to pay a dividend because of a loan made solely for the purpose of enabling the shareholder, or an associate of the shareholder, to acquire an ESS interest under an employee share scheme (within the meaning of the Income Tax Assessment Act 1997) to which:

(a) Subdivision 83A-B, and the provisions referred to in paragraphs 83A-33(1)(a) to (c), of that Act apply; or

(aa) Subdivision 83A-B, and the provisions referred to in paragraphs 83A-35(1)(a) and (b), of that Act apply; or

(b) Subdivision 83A-C of that Act applies.

Subsection 83A-20(1) of the ITAA 1997 provides that Subdivision 83A-B applies to an employee share scheme ('ESS') interest acquired by an entity under an employee share scheme at a discount.

An ESS interest in a company is defined in subsection 83A-10(1) of the ITAA 1997 as either a beneficial interest in a share in the company or a beneficial interest in a right to acquire a beneficial interest in a share in the company.

However, subsection 83A-20(2) of the ITAA 1997 states that Subdivision 83A-B does not apply if the ESS interest is a beneficial interest in a share acquired by the entity as a result of exercising a right, if the beneficial interest in the right was acquired by the entity under an employee share scheme.

The Associates have already been provided options by CompanyA under an employee share scheme. The proposed loans by CompanyA will be made for the purpose of enabling the Associates to exercise their existing options in order for them to acquire shares in CompanyA.

Subdivision 83A-B of the ITAA 1997 will not apply as the CompanyA shares will be acquired by the Associates as a result of the Associates' exercising the options, which were acquired by them under an employee share scheme. Consequently Subdivision 83A-C of the ITAA 1997 will also not apply (subsection 83A-105(1) of the ITAA 1997).

Therefore, as the loans are not provided solely for the purpose of enabling the Associates to acquire ESS interests under an employee share scheme to which Subdivision 83A-B or Subdivision 83A-C applies, section 109NB will not apply.

Question 2

Summary

The loans made by CompanyA to the Associates will not be deemed dividends under section 109D of the ITAA 1936, as its operation would be excluded due to section 109N of the ITAA 1936.

Detailed reasoning

As stated in question 1 above, the loans provided to the Associates by CompanyA could satisfy subsection 109D(1) of the ITAA 1936 if the Associates do not fully repay the loan before the lodgement day in the income year in which the loan is made and none of the exceptions in Subdivision D of the ITAA 1936 apply.

Subdivision D of the ITAA 1936 details certain loans that are not treated as dividends, and thus are excluded from the operation of section 109D of the ITAA 1936. Section 109N(1) in Subdivision D of the ITAA 1936 provides that:

A private company that makes a loan to an entity in one of the private company's years of income is not taken under section 109D to pay a dividend at the end of the year of income because of the loan if, before the lodgment day for the year of income:

(a) the agreement that the loan was made under is in writing; and

(b) the rate of interest payable on the loan for years of income after the year in which the loan is made equals or exceeds the benchmark interest rate for the year; and

(c) the term of the loan does not exceed the term (the maximum term) for that kind of loan worked out under subsection (3).

Taxation Determination TD 2015/15 'Income tax: what is the benchmark interest rate applicable for the year of income that commenced on 1 July 2015 for the purposes of Division 7A of Part III of the Income Tax Assessment Act 1936 and how is it used?' provides that the benchmark interest rate for the year ending 30 June 2016 for the purposes of section 109N of the ITAA 1936 is 5.45% per annum. The maximum term for the loan is 7 years pursuant to paragraph 109N(3)(b) of the ITAA 1936.

The Applicant has advised that the loans by CompanyA to the Associates will be made in writing and the loan term is for 7 years with an interest rate payable at X% per annum. Therefore, as the criteria in section 109N of the ITAA 1936 are satisfied, the loans will not be deemed dividends under section 109D of the ITAA 1936.

Question 3

Summary

There will be no forgiveness of a debt if CompanyA will acquire the Associates' shares for the value of the loans, as the debt would be repaid in full.

If CompanyA acquire the Associates' shares for market value of the shares (which is less than the value of the loans), then there will be a forgiveness of a debt as the debt is considered to be extinguished other than by repayment of the debt in full. However, as the value of the debt when it is forgiven is equal to the amount offset under section 245-65 of the ITAA 1997, the gross forgiven amount of the debt is nil. Therefore, Subdivisions 245-D to 245-F of the ITAA 1997 do not apply in respect of the debt.

Detailed reasoning

Division 245 of the ITAA 1997 applies to any commercial debt that is forgiven. Paragraph 245-10(a) of the ITAA 1997 provides that a debt will be considered to be a commercial debt if the whole or any part of the interest payable in respect of the debt can be deducted by the debtor.

The loan term is for 7 years with an interest rate payable at X% per annum. The debt is used to purchase shares in CompanyA, which would be reasonably expected to generate income from dividends. The applicant has advised that the Associates would be able to claim income tax deductions for any interest payable on the loans, as the loans were used by the Associates for income producing purposes.

Accordingly, the loan from CompanyA to the Associates constitutes a commercial debt and Subdivisions 245-C to 245-G of the ITAA 1997 would apply.

Paragraph 245-35(a) of the ITAA 1997 provides that a debt is forgiven if and when the debtor's obligation to pay the debt is released or waived or is otherwise extinguished other than by repaying the debt in full.

If the Associates are unable to repay the loans when they become due, CompanyA will either acquire the Associates' shares in CompanyA:

• for the value of the loans, if the value of the shares is not less than the exercise price (the exercise price equals the value of the loans); or

• for the market value of the shares, if the value of the shares have depreciated in price below the exercise price (the exercise price equals the value of the loans).

There will be no forgiveness of a debt if CompanyA will acquire the Associates' shares for the value of the loans, as the debt would be repaid in full.

However, there will be a forgiveness of a debt if CompanyA acquires the Associates' shares for market value of the shares, which is less than the value of the loans. The debt will be considered to be extinguished other than by repayment of the debt in full.

The general rule for working out the value of a debt is contained in section 245-55 of the ITAA 1997. However, special rules exist for working out the value of a non-recourse debt in section 245-60 of the ITAA 1997.

Section 245-60 ITAA 1997 provides that:

(1) The value of a debt when it is * forgiven is the lesser of:

(a) the amount of the debt outstanding at that time; and

(b) the * market value at that time of the creditor's rights mentioned in paragraph (2)(b).

(2) Subsection (1) applies to a debt if:

(a) you incurred the debt directly in respect of financing:

(i) the acquisition of property by you; or

(ii) the construction or development of property by you;

(but not including the manufacture of goods); and

(b) the creditor's rights against you in the event of default in the payment of the debt or interest were, just before the debt was forgiven, limited to all or any of the following:

(i) rights (including the right to money payable) in relation to all or any of the matters mentioned in subsection (3);

(ii) rights in respect of a mortgage or other security over the property;

(iii) rights arising out of any * arrangement relating to the financial obligations, in relation to the property, of the * end user of the property to you.

(3) For the purposes of subparagraph (2)(b)(i), the matters are as follows:

(a) the property or the use of the property;

(b) goods produced, supplied, carried, transmitted or delivered by means of the property;

(c) services provided by means of the property;

(d) the loss or * disposal of the whole or a part of the property or of your interest in the property.

The Associates incurred the debt directly in respect of financing the acquisition of CompanyA shares. CompanyA's, rights, as creditor, against the Associates in the event of default is limited to rights in relation to the Associates' CompanyA shares. Therefore, as the loan terms in the event of a default satisfy the conditions in subsection 245-60(2) of the ITAA 1997, the value of the debt when it is forgiven is the market value of the shares CompanyA acquires from the Associates in the event of default (subsection 245-60(1) of the ITAA 1997).

The rules to determine the amount that can be offset against the value of a debt are set out in section 245-65 of the ITAA 1997. In this case item 2 of the table in subsection 245-65(1) of the ITAA 1997 will apply as:

n the debt is not a moneylending debt; and

n items 3, 4, 5 and 6 do not apply (as the conditions in subsection (2) are not met, the debt is not assigned and the debt is not forgiven by subscribing for shares in a company).

In accordance with item 2 in subsection 245-65(1) of the ITAA 1997, the amount offset against the value of the debt is the market value of the shares at the time of forgiveness that the Associates have given, or are required to give to CompanyA.

As the value of the debt when it is forgiven is equal to the amount offset, there is no gross forgiven amount in respect of the debt (section 245-75 of the ITAA 1997). Therefore, subdivisions 245-D to 245-F of the ITAA 1997 do not apply in respect of the debt (subsection 245-75(2) of the ITAA 1997).

Question 4

Summary

The loan would have been taken to be a dividend under section 109D of the ITAA 1936 if section 109N of the ITAA 1936 was disregarded. Therefore the provision of the loans to the Associates' by CompanyA will not be a fringe benefit, as they are excluded by paragraph (s) of the definition of a fringe benefit in subsection 136(1) of the FBTAA.

Detailed reasoning

A fringe benefit is defined in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 (Cth) ('FBTAA') to be a benefit provided by the employer to an employee or an associate of an employee 'in respect of' the employment of the employee. However, certain benefits are excluded from being a fringe benefit by virtue of paragraphs (f) to (s) of the fringe benefit definition.

The definition of a fringe benefit in paragraph 136(1)(s) of the FBTAA states that a fringe benefit does not include:

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

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

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

As stated for question 2 above, the loan provided by CompanyA to the Associates is a loan within the meaning of section 109D of the ITAA 1936, but is not taken to be a deemed dividend because section 109N of the ITAA 1936 applies.

However, as a dividend would have been taken to be paid under section 109D of the ITAA 1936 in relation to the loan if section 109N of the ITAA 1936 was disregarded, the exclusion in paragraph (s) would apply.

Therefore, the provision of the loans to the Associates' by CompanyA will not be a fringe benefit, as they are excluded by paragraph (s) of the definition of a fringe benefit in subsection 136(1) of the FBTAA.