Edited version of private advice

Authorisation Number: 1051403487624

Date of advice: 23 July 2018

Ruling

Subject: Be a loan

Question 1

Will the payments in the years ended 30 June 2018 and 30 June 2019 by the Co to the partnership >be a loan for the purposes of subsection 109D(1) of the Income Tax assessment Act 1936 ( ITAA 1936)?

Answer

Yes

Question 2

Would the deemed dividend under Division 7A of the ITAA 1936 at the end of the 2018 and 2019 income years be reduced to nil to the extent that the Co has no distributable surplus in respect of the 2018 and 2019 years pursuant to section 109Y of the ITAA 1936?

Answer

Yes

Question 3

Will any of the provisions of Part IVA of the ITAA 1936 apply to the proposed arrangement during the ruling period?

Answer

No

This ruling applies for the following periods:

Income year ending 30 June 2018

Income year ending 30 June 2019

The scheme commences on:

1 July 2017

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A partnership of discretionary trusts, is renovating its business.

It's proposed that a related company (the Co) will borrow funds from its nominated financial institution, and on-lend these funds to the partnership for the renovations.

The Co and partnership will enter into a loan agreement and make repayments to the loan owed to the Co.

The Co will charge interest to the partnership at the same commercial arm's length rate.

The retained earnings will be paid via a dividend to the shareholder to ensure the Co has no retained earnings before entering into the borrowing arrangement.

The partnership will enter into a formal loan agreement with the Co.

The Co will not receive any distribution from associated trusts.

The Co will have no retained earnings at 30 June 2018.

The loan from the Co to the partnership will not be a compliant agreement under section 109N of the Income Tax Assessment Act 1936 (ITAA 1936).

A formal loan agreement will be entered into but it will not meet the criteria for the maximum term of the loan under section 109N of the ITAA 1936.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 177A

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177C

Income Tax Assessment Act 1936 subsection 177C(1)

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1936 subsection 177F(1)

Income Tax Assessment Act 1936 section 103A

Income Tax Assessment Act 1936 Division 7A of Part III

Income Tax Assessment Act 1936 subsection 103A(1)

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 subsection 109D(1)

Income Tax Assessment Act 1936 section 109N

Income Tax Assessment Act 1936 subsection 109N(1)

Income Tax Assessment Act 1936 subsection 109N(3)

Income Tax Assessment Act 1936 section 109Y

Income Tax Assessment Act 1936 subsection 109Y(1)

Income Tax Assessment Act 1936 subsection 109Y(2)

Income Tax Assessment Act 1936 subsection 109Y(3)

Reasons for decision

Question 1

Summary

The loan made by the Co to the partnership is considered to be a loan for the purpose of subsection 109D(1) of the ITAA 1936.

Detailed reasoning

Subsection 109D(1) of the ITAA 1936 provides that:

A private company is taken to pay a dividend to an entity at the end of one of the private company's years of income (the current year) if:

(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) Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and

(d) either:

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

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

Private Company

Subsection 103A(1) of the ITAA 1936 defines a private company as a company which is not a public company. The meaning public company is found in the remainder of section 103A. The Co does not fit the meaning of public company as set out in these provisions so it is therefore a private company.

However, section 109D does not apply if all the criteria in section 109N of the ITAA 1936 are satisfied.

Application of Subdivision D of the ITAA 1936

Subdivision D of Division 7A of Part III of the ITAA 1936 sets out what sorts of loans are not treated as dividends.

Section 109N of the ITAA 1936 provides that a loan made by a private company in one of its income years to an entity is not taken to be a dividend at the end of the year of income for the purposes of section 109D of the ITAA 1936 if the loans comply with certain interest rate and maximum term requirements.

Subsection 109N(1) of the ITAA 1936 prevents a loan from being treated as a dividend under section 109D of the ITAA 1936 if all of the following three conditions are satisfied:

(a)          the loan was made under a written agreement. This implies that the written agreement must be in place before the loan transaction.

(b)          The interest rate on the loan for years of income after the year in which the loan is made is equals to or exceeds the "benchmark interest rate" for the year, that is, the Indicator Lending Rates Bank Variable housing loan interest rate last published by the Reserve Bank of Australia before the start of the income year.

(c)           The benchmark interest rate for the year is intended to refer to the benchmark interest rate for each of the years of income in which the loan subsists.

(d)          The term of the loan does not exceed the 'maximum term' for the loan

(e)          The maximum term of a loan is specified in subsection 109N(3) of the ITAA 1936 as either:

−        25 years if the loan is secured by a registered mortgage over real property as to 100% of its value and the market value of the property at the time of the loan is made (less any other loans secured over that property in priority to that loan) is at least 110% of the amount of the loan; or

−        Seven years for other loans (eg unsecured loans or loans over other types of property or loans not complying with the 110% valuation requirements).

In this situation, the loan does not satisfy the requirements of section 109N as it will not meet all of the criteria within the section.

The loan will be in writing and the Co will be borrowing funds and on charge the interest rate to the partnership and it will be greater than the ATO benchmark rate.

However, the applicant has stated that the loan will exceed the maximum 25 year term for the loan and will not be secured over real property as required under section 109N of the ITAA 1936.

Conclusion

Therefore, as the loan does not meet the criteria contained in section 109N of the ITAA 1936, the loan will be deemed a dividend for the purposes of subsection 109D(1) of the ITAA 1936.

Question 2

Summary

The Co loan to the partnership is a deemed dividend under section 109D of the ITAA 1936, and the amount of deemed dividend arising from the loan will be reduced to nil as the Co will have a nil distributable surplus for the year ended 30 June 2018.

Detailed reasoning

Subsection 109Y(1) of the ITAA 1936 sets out that if, at the end of the income year, the sum of all the Division 7A deemed dividends that a private company is taken to pay would be more than the company's distributable surplus for that year, the amount of each dividend is worked out using the formula in subsection 109Y(3).

Subsection 109Y(2) of the ITAA 1936 provides the formula for calculating a private company's distributable surplus.

Subsections 109Y(1) and (3) together, effectively limit the quantum of the deemed dividend to the extent of the private company's distributable surplus for that year of income.

In this situation, the Co had retained earnings and they will be paid out via a dividend to the shareholder to ensure that the Co has no retained earnings before entering into the borrowing arrangement with the partnership.

The Co will not receive any distributions from associated trusts and the Co will incur interest to the bank that will be recovered from the partnership. Therefore, the Co will have no retained earnings at 30 June 2018.

The Commissioner accepts the Co's distributable surplus calculations result in amounts significantly less than zero for the year ended 30 June 2018.

Conclusion

The Co has made a loan to the partnership which is taken to be a deemed dividend under section 109D of the ITAA 1936, and the amount of deemed dividend arising from the loan will be reduced to nil because the Co will have a nil distributable surplus for the year ended 30 June 2018.

Question 3

Summary

The general anti-avoidance provisions in Part IVA of the ITAA 1936 will not apply to the arrangement.

Detailed reasoning

Part IVA of the ITAA 1936 contains a number of general anti-avoidance provisions that give the Commissioner the discretion to cancel a tax benefit that has been obtained, or would, but for the operation of section 177F, be obtained by the taxpayer in connection with a scheme to which Part IVA applies. This discretion is found in subsection 177F(1).

Before the Commissioner can exercise the discretion in subsection 177F(1), the requirements of Part IVA must be satisfied. These requirements are that:

(i)            a 'tax benefit', as identified in section 177C, was or would, but for subsection 177F(1), have been obtained;

(ii)           the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A; and

(iii)          having regard to section 177D, the scheme is one to which Part IVA applies.

Scheme

A scheme is broadly defined in subsection 177A(1) of the ITAA 1936 to be:

(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.

In Federal Commissioner of Taxation v Hart [2004] HCA 26, it was noted that the definition of scheme encompasses not only a series of steps which together can be said to constitute a 'scheme' or a 'plan' but also the taking of but one step. It was further stated that in a given case, a wider or narrower approach may be taken to the identification of a scheme.

In the present case it is considered that the scheme is the arrangement between the Co and the partnership for the Co to borrow funds from a bank and on-lend to the partnership to allow the partnership to repay the funds used for renovations.

As such there is a scheme for the purposes of 177A of the ITAA 1936.

Tax benefit

Part IVA only applies to a scheme where a taxpayer has obtained a tax benefit in connection with the scheme. Paragraph 61 of Practice Statement Law Administration 2005/24 (Application of General Anti-Avoidance Rules) provides that the scheme ultimately matters only in the context of whether there is a tax benefit obtained by the taxpayer in connection with the scheme.

Subsection 177C(1) of the ITAA 1936 defines four kinds of tax benefit, relating broadly to:

(i)            an amount not being included in the assessable income of the taxpayer of a year of income; or

(ii)           a deduction being allowable to the taxpayer in relation to a year of income; or

(iii)          a capital loss being incurred by the taxpayer during a year of income; or

(iv)          a foreign tax credit being allowable to the taxpayer.

In the present case, the Co will borrow money and on lend these funds to the partnership.

The Co's current retained earnings will be paid out via a dividend to realise no retained earnings held by the Co before entering into the loan agreement.

The Co will be charging the interest at the same rate as the interest it is changed by the bank.

No tax benefit can be identified under the proposed scheme in accordance with subsection 177C(1) of the ITAA 1936 which (relevantly) includes:

(a)          an amount not being included in the assessable income of the taxpayer...

This provision is not relevant in this case as amounts are being included in assessable income.

(b)          (b) a deduction being allowable to the taxpayer which would not have been allowable to the taxpayer if the scheme had not been carried out...

In this case, there is no additional amount of deductions being incurred in the group structure as the interest charged by the Co to the partnership is at the same commercial arm's length rate as the interest that will be changed by the bank.

(ba) a capital loss being incurred by the taxpayer...

This provision is not relevant in this case as the scheme does not involve a capital loss.

(bb) a foreign income tax offset being allowable to the taxpayer...

This provision is not relevant in this case as the scheme does not involve a foreign Income tax offset.

Conclusion

It is considered that based on the facts provided Part IVA of the ITAA 1936 will not apply to the scheme as the applicant has not obtained a tax benefit in connection with the scheme.