Edited version of your written advice

Authorisation Number: 1051425219108

Date of advice: 5 September 2018

Ruling

Subject: Money Lending and Loans to Related Parties

Question One

Is the Taxpayer conducting a business of money lending for the purposes of paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) and, as a result entitled to a deduction for bad debts written off pursuant to subsection 25-35(1) of the ITAA 1997 where the relevant requirements are satisfied?

Answer

Yes.

Question Two

If the answer to Question One is ‘Yes’, will the formation of a tax consolidated group, of which the Taxpayer would be the head entity, result in the Taxpayer ceasing to carry on the business of money lending for the purposes of paragraph 25-35(1)(b) of the ITAA 1997?

Answer

No.

Question Three

Are the loans made by the Taxpayer to related parties excluded from the application of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) pursuant to section 109M of the ITAA 1936?

Answer

No.

Question Four

If the answer to Question Three is ‘No’, would section 109M of the ITAA 1936 be satisfied such as to exclude loans from the application of section 109D of the ITAA 1936 should the terms of existing loans provided to related parties be modified, particularly in respect to the loan period, interest rate, regularity of repayments and nature of security held?

Answer

Yes.

Question Five

Is the Taxpayer a financial institution for the purposes of the application of Taxation Ruling TR 94/32 with respect to non-accrual loans?

Answer

No.

This ruling applies for the following period(s)

1 July 2017 to 30 June 2021.

The scheme commences on

1 July 2017.

Relevant facts and circumstances

The Taxpayer is a private company incorporated in Australia, and is part of a broader family group.

The Taxpayer does not have a lending license or an Australian Financial Services Licence. The Taxpayer is not registered as a money lender and is not governed by the Australian Prudential Regulation Authority.

Lending activities

In the 20XX income year, the Taxpayer commenced its lending activity to related and unrelated third parties.

The Taxpayer does not lend or advertise its services to the general public. With limited exceptions, the Taxpayer’s lending is limited to borrowers within a specific industry.

The Taxpayer has no direct employees. Staff are employed by a related entity of the broader family group and their services are charged to the Taxpayer at a commercial rate.

Key individuals have significant experience in the applicable industry.

Unlike a bank, the Taxpayer has not typically sourced funds for lending from deposits (the Taxpayer is not an authorised deposit taking institution) but from a combination of:

● external financiers, and

● related parties – from borrowing and distributions from related parties.

The Taxpayer pays interest on funds that it obtains from external financiers and related parties.

Distributions from related parties are brought to account as assessable income.

The Taxpayer’s business goal is to maximise the returns and profits from its lending activities.

The Taxpayer accounts for interest income on loans on an accrual basis.

The Taxpayer does not rely solely on receiving interest income on its loans and apply a risk/reward approach to obtain other income from the same arrangements.

For some loans (both related and unrelated parties), the Taxpayer also charges a fee. This may be a:

● fixed rate fee – a fee based on feasibility profit of the particular project, and

● variable risk fee – an agreed percentage share of the final profit from the project should it vary positively to the original feasibility profit report.

The intention is to supplement the interest income that the Taxpayer receives with a fee linked to the success of the project.

Such arrangements are only ever incorporated as part of the loan itself and enable the Taxpayer to earn additional income and higher profits from its lending activities.

The loans that the Taxpayer has made to unrelated third parties are subject to individual assessment and:

● commercial rates of interest which vary for each loan depending on a variety of factors including amount loaned, loan period, specific risk factors, nature of security taken

● varying amounts depending on the borrower’s needs, the Taxpayer’s assessment and the level of the Taxpayer’s available funds

● loan agreements specific to the borrower and the project, and

● the taking of security.

The loans that the Taxpayer has made to related parties are subject to:

● individual loan agreements for each project

● what is typically described as ‘Division 7A terms’ – regarding interest rate (benchmark interest rate) and loan period (seven years for unsecured loans and 25 years for loans secured by real property) – on the basis that the Taxpayer:

● considered such terms to be minimum terms

● considered it would ensure they would not risk the application of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) to such loans

● expect that most, if not all, such loans would be repaid inside the loan period – in some cases, such loans have been repaid within 18 to 24 months, and

● varying amounts depending on the borrower’s needs, the Taxpayer’s assessment and the level of the Taxpayer’s available funds.

Source of borrowers

The Taxpayer does not advertise its lending activities or services to the general public. Instead, the Taxpayer sources borrowers in three ways:

● personal networks and relationships

● repeat business – the Taxpayer has advanced new loans to borrowers to whom it has previously lent, and

● brokers – while there are no direct relationships or agreements, again through contacts and relationships, some brokers have become aware of the Taxpayer’s lending activities.

Process for assessing loan applications

Process for unrelated parties

Once a potential loan is identified, the Taxpayer has a detailed process of reviewing the potential terms of each loan to unrelated third parties, which includes the following:

● The suitability of the project and the financial metrics are dealt with as separate steps in the process.

● The team’s experience in the particular industry is applied to review the project’s plan. In some cases, the team has actually provided assistance to the borrower to complete or improve the plan (this is a specialised service that the Taxpayer does not charge for but use as part of its overall lending process).

● Only if the plan meets certain minimum criteria will it then be considered for a loan.

● Only then is the plan and proposed loan terms considered from a financial perspective. Only if the project itself and the financials meet the Taxpayer’s requirements will formal loan documentation be prepared.

● Terms specific to each loan are agreed upon regarding:

● Amount loaned

● Interest rate

● Loan period

● Nature of security

● Reporting requirements, and

● Minimum loan to value covenants.

Not all loan proposals for unrelated third parties are accepted, however the acceptance rate may be higher than other lenders (e.g. banks) largely because the class of borrowers is narrow and somewhat of a known quantity before the detailed review process commences.

Process for related parties

With respect to loans to related parties, the same process as detailed above for loans to unrelated parties is applied, however with the following differences:

● The personnel who review loan opportunities are the same as those who identify the Taxpayer’s (and the broader family group’s) own project opportunities – that is, they have already undertaken the same assessment internally

● There is complete access to all documents, records and financial information of the related party

● There is control over the project activities, budgets, schedules, reporting etc

● Terms regarding interest rate and loan period:

● Division 7A loan terms are applied for the meeting of minimum requirements to ensure there is no risk of Division 7A applying to deem loans to be dividends

● Even though the loan periods are either seven years (unsecured) or 25 years (secured by real property), the intention is that they will be paid off upon completion of the project for which the loan was made. As with loans to unrelated third parties, this means they are typically repaid anywhere between two and six years, although as some of the projects have experienced delays, full repayment may ultimately take longer.

All loans to both unrelated third parties and related parties are subject to detailed ongoing monitoring, the extent to which depends upon the status of the project being funded.

Recovery of loans

The Taxpayer’s business plan is focussed on lending for the purpose of deriving a profit. However, there have been issues with recovery of some loans. When this occurs, the Taxpayer considers various means of limiting the loss (or maximising recovery). Alternative means that the Taxpayer considers and/or adopts include selling the debt to a third party or appointing another entity related to it that has the relevant experience to complete the project, with the aim of recovering most or all of the debt.

As an example of a loan that has been provided for which there were recovery issues, the Taxpayer recently had lent $XX million to a third party borrower which experienced financial difficulty. Given the stage of the project, the Taxpayer determined that receivership or some other form of formal administration would significantly restrict their return. Therefore, an alternative mechanism for recovery had been instituted involving:

● the Taxpayer establishing a wholly-owned subsidiary

● the subsidiary acquiring the asset from the borrower at market value to allow for recovery of some of the debt, and

● the subsidiary is to complete the project and use profits from the project delivery to recover as much of the remaining debt as possible.

Company A was incorporated in 20XX as a wholly-owned subsidiary of the Taxpayer. At this time, a group that could form a consolidated tax group comprising the Taxpayer and Company A came into existence.

Company A is a special purpose vehicle established to undertake a single project, being the completion of a particular project. Company A expects to generate significant revenue upon completion of the project.

Proposed amendment to terms of loan agreements for related parties

To date, the terms of the loans have differed between unrelated parties and related parties with respect to:

● interest rate

● repayment terms, and

● length of loan.

The primary reason for these differences related to the Taxpayer’s concern that if they were not a money-lender for income tax purposes, the loans with related parties would not have satisfied the minimum conditions for complying with Division 7A of the ITAA 1936 and, consequently, the loans would result in deemed unfrankable dividends.

As such, the loan agreements for loans to related parties were written in a manner so that they would be compliant with section 109N of the ITAA 1936 (‘Loans meeting criteria for minimum interest rate and maximum term not treated as dividends’) to ensure there would be no risk of the application of Division 7A.

However, in terms of loans to related parties, the Taxpayer would prefer leniency (compared to Division 7A loan terms) as it is known that, for projects which take longer than 12 months, the borrower does not have cash-flow to support annual repayments. For example, repayments are only capable of being made when the project is completed and income is generated.

Therefore, the Taxpayer now proposes to amend the terms of the agreements under which it makes loans to related parties so that the borrower does not need to make minimum yearly repayments and that repayment would be due after the project has been completed. While this would have the effect of making the agreements for loans to related parties no longer compliant with section 109N of the ITAA 1936, the Taxpayer is seeking to apply section 109M of the ITAA 1936 (‘Loans made in the ordinary course of business on arm’s length terms not treated as dividends’) to these loan agreements that it proposes to modify for the purposes ensuring no risk of the application of Division 7A.

The Taxpayer has developed a ‘template’ for loans to related parties going forward, which it contends includes the usual terms on which the Taxpayer makes similar loans to parties at arm’s length.

This ‘template’ includes a number of key terms and conditions which the Taxpayer expects to have a level of consistency (where ‘consistency’ in this sense is not intended to mean ‘exactly the same’), as follows:

● Interest rate – would differ on a loan by loan basis, but would comprise a Lower Rate and a Higher Rate dependent on the specific risk attached to the loan and the underlying project being financed by the loan.

● Loan period – would typically be between 12 and 36 months, but more specifically tied to the period required to complete the underlying project being financed by the loan (rather than being a standard period such as seven or 25 years as would be typical of a complying Division 7A loan agreement).

● Repayment – would require repayment in full (including interest) at the end of the loan period, rather than regular repayments (whether annual or more regular) through the loan period.

● Security – would always be taken, but the nature and priority of the security would depend on the specific risk attached to the loan, whether there are other financiers (with higher ranking security) and the type of assets the borrowers have available to provide as security.

The Taxpayer proposes that, if the Commissioner is in agreement with the Taxpayer’s position:

● the terms of its current loans with related parties would be amended to terms consistent with those in the template, and

● future loans made to related parties would be entered into on terms consistent with those in the template.

Example loans

The Taxpayer has submitted examples of (existing) loans provided to related and unrelated parties.

The Taxpayer has also provided an example (or ‘template’) loan agreement for loans to related parties going forward.

Assumption

The Taxpayer, as the head company, made a written choice to form a consolidated tax group with its wholly-owned subsidiary, Company A, in the 20XX income year.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Section 109D

Income Tax Assessment Act 1936 Section 109M

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 8-10

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Subsection 25-35(1)

Income Tax Assessment Act 1997 Paragraph 25-35(1)(b)

Income Tax Assessment Act 1997 Section 701-1

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Question One

Is the Taxpayer conducting a business of money lending for the purposes of paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) and, as a result entitled to a deduction for bad debts written off pursuant to subsection 25-35(1) of the ITAA 1997 where the relevant requirements are satisfied?

Summary

Yes, the Taxpayer is in the business of lending money. It conducts its activities in a business-like manner with a degree of repetition and regularity. The scale of the lending is significant such that the Taxpayer’s money lending is not ancillary or incidental to another part of its business. It is apparent that the Taxpayer is conducting its money lending activity with a view to profit.

Detailed reasoning

Section 8-1 of the ITAA 1997 deals with general deductions and provides the circumstances where you may deduct from your assessable income, certain losses or outgoings. Subsection 8-1(1) states that you may deduct losses or outgoings to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

However, under subsection 8-1(2) of the ITAA 1997, certain exclusions exist to prevent you from deducting a loss or outgoing to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income; or

(d) a provision of this Act prevents you from deducting it.

Section 8-10 of the ITAA 1997 indicates that if more than one provision applies, the most appropriate provision should be used. If there is a more specific section, it would be the section most appropriate.

Division 12 of the ITAA 1997 sets out particular types of deductions that are dealt with by a specific provision of either the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997. In particular, Division 12 lists that the rules in relation to deduction of general bad debts are provided for by section 25-35 of the ITAA 1997.

Subsection 25-35(1) of the ITAA 1997 provides the circumstances that must exist so that you can deduct a bad debt that you have written off in an income year. These circumstances are:

(a) it was included in your assessable income for the income year or for an earlier income year; or

(b) it is in respect of money that you lent in the ordinary course of your business of lending money.

Note: If a bad debt is in respect of a payment that is required to be made under a qualifying security (within the meaning of Division 16E of Part III of the Income Tax Assessment Act 1936): see subsection 63(1A) of that Act.

In order to claim a bad debt under paragraph 25-35(1)(b) of the ITAA 1997, it is necessary to demonstrate that the entity is carrying on a business as a moneylender and that the bad debt claimed related to money which was lent in the ordinary course of that business.

Carrying on a business as a moneylender

Generally, the requirements to be considered to be carrying on a business as a moneylender are similar to those required for carrying on of any business.

Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

The question of whether a business is being carried on is a question of fact and degree. The Courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) provides the Commissioner’s view of the factors used to determine if a taxpayer is in business for tax purposes.

In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

● whether the activity has a significant commercial purpose or character

● whether the taxpayer has more than just an intention to engage in business

● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

● whether there is regularity and repetition of the activity

● whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

● the size, scale and permanency of the activity, and

● whether the activity is better described as a hobby, a form of recreation or sporting activity.

No one indicator is decisive. The indicators must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

Taxation Ruling 92/18 Income tax: bad debts (TR 92/18) provides the Commissioner's view in relation to the deductibility of bad debts. Whilst the ruling considers this in relation to the ITAA 1936, the same principles apply in respect of the ITAA 1997.

TR 92/18 reiterates that the question of whether a business of money lending is being carried on is a question of fact. It also indicates that in assessing the facts, a money lender may not necessarily need to be willing to lend to the public or a wide class of borrowers. Further, the taxpayer may lend to only certain classes, however this must be done in a business-like manner with a view to yielding a profit from that activity.

Bowen CJ in FC of T v. Marshall and Brougham Pty Ltd 87 ATC 4522: 18 ATR 859 (Marshall and Brougham) made the following observations regarding a business of money lending:

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in ones dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.

In Litchfield v. Dreyfus [1906] 1 KB 584 at p. 589, Farwell J stated that:

Speaking generally, a man who carries on a money-lending business is one who is ready and willing to lend to all and sundry, provided that they are from his point of view eligible.

However, this should not restrict the meaning of 'money-lender' for taxation purposes in light of the more recent Australian cases of Fairway Estates Pty Ltd v. Federal Commissioner of Taxation (1970) 123 CLR 153; (1970) 70 ATC 4061; (1970) 1 ATR 726, Marshall and Brougham and FC of T v. Bivona Pty Ltd 90 ATC 4168; 21 ATR 151.

These recent cases have highlighted the differences between laws relating to the control of money lenders and the laws relating to the taxing of money lenders.

Further, in the case of Richard Walter Pty Ltd v. FC of T 95 ATC 4440 Tamberlin J stated that:

…it is not enough merely to show that a person has on several occasions lent money at remunerative rates of interest; there must be a certain degree of continuity and system about the transactions. The activity should be capable of being described as business operations intended to yield a profit.

Non-registration as a money lender is only one circumstance to be considered and is not decisive. In Administrators of Estate of Stewart v. C of T (NSW) (1935) 3 ATD 271, it was held that, despite non-registration as a money lender, the taxpayer was carrying on a money lending business.

In Fairway Estates Pty Ltd v. Federal Commissioner of Taxation (1970) 123 CLR 153; 70 ATC 4061; (1970) 1 ATR 726, Barwick CJ said that 'provided there is an intention to carry on a money lending business, such a business can exist even though only one loan has been made'. Therefore, it is possible for an entity to carry on a money lending business with only a few borrowers.

In Federal Commissioner of Taxation v. Bivona Pty Ltd (1990) 21 FCR 562; 90 ATC 4168; (1990) 21 ATR 151, the taxpayer company was incorporated for the purpose of borrowing money overseas ($4 million in Swiss francs) for use by a group of companies of which it was a member.

It was concluded that the taxpayer's principal business was money lending as approximately 83% of the taxpayer's gross income was interest received from the holding company and a further 7% was interest received from unrelated companies.

The loan to the holding company yielded a profit (that is, the interest received exceeded the interest paid to the overseas lender).

Accordingly, for the purposes of taxation law, a money lender does not have to necessarily be ready and willing to lend money to the public at large, or to a wide class of borrowers. Registration as a money lender and the number of borrowers does not conclusively determine that a business of money lending is being carried on. In addition, it is sufficient if a taxpayer lends money to certain classes of borrowers, provided the taxpayer does so in a business-like manner with a view to yielding a profit from that activity.

Application to the Taxpayer’s circumstances

The Taxpayer has conducted its activities over a number of years. The Taxpayer has been involved in money lending since 20XX. A breakdown of the loans that the Taxpayer has issued to both related and unrelated parties since 20XX has been provided. This activity shows elements of repetition and regularity in running a money lending business. The number of loans issued over the years also demonstrates that no loan was a single and isolated transaction.

The scale of the Taxpayer’s lending activity is significant. The Taxpayer lends money to specific related and unrelated parties. In the 20XX income year, the Taxpayer derived interest income of $XX million. The proportion of assessable interest on loans has ranged between XX% and XX% with a large proportion of assessable income being from related party trust distributions to the Taxpayer. The scale of lending money is significant as such that the income derived from loans is not ancillary or incidental to another part of its business. It also demonstrates the Taxpayer’s intention to carry on a money lending business.

In respect to related party loans, the Taxpayer has been charging the benchmark interest rate on these loans to date. Some loans for projects also charge a fixed risk fee or a variable risk fee in order to derive a profit.

In relation to unrelated party loans, the rate of interest charged is negotiated and documented in each loan agreement. The rate is fixed at what is considered to be a commercial rate based on the amount loaned, loan period, specific risk factors (of the project and the borrower itself) and the nature of security taken. Some loans for projects also charge a fixed risk fee or a variable risk fee in order to derive a profit.

The commercial approach to setting interest rates on these loans demonstrates the Taxpayer’s profit-making intention in relation to its lending activities.

The Taxpayer has a standard loan process for approval of loans which varies depending on the nature of the borrower. All approved loans are monitored given their value to the group. The monitoring process between internal and external loans is similar. The Taxpayer has a credit recovery process in place. The Taxpayer has developed policies to monitor and action loan defaults. It would appear these activities are being conducted in a structured and systematic way which demonstrates a commercial purpose in running a business of money lending.

The Taxpayer has acknowledged that it is not registered as a money lender. However, non-registration as a money lender is only one circumstance to be considered and is not decisive in determining whether the Taxpayer is not in the business of money lending.

In examining the Taxpayer’s lending activities, it can be seen that it is conducting those activities in a structured and systematic way that demonstrates commercial purpose. It conducts its activities in a business-like manner with a degree of repetition and regularity. The scale of the lending is significant such that its money lending is not ancillary or incidental to another part of its business. It is apparent that the Taxpayer is conducting its money lending activity with a view to profit. The Taxpayer is not conducting an activity that is better described as a hobby, a form of recreation or sporting activity.

Bad debts between Head Company and subsidiaries

For completeness, it should be noted that – in accordance with Taxation Determination TD 2004/37 Income tax: consolidation: are intra-group money lending transactions or dealings taken into account in determining if the head company of a consolidated group is carrying on a business as a money lender? – any loan(s) between the head company and a subsidiary will not be taken into account in determining whether the head company of a consolidated group is carrying on business as a money lender for income tax purposes. For the purposes of Question One, excluding this loan will not affect the conclusion that the Taxpayer is a money lender.

Therefore, on the balance of facts presented, it is considered that the Taxpayer is carrying on a business of lending money for the purposes of section 25-35 of the ITAA 1997.

Question Two

If the answer to Question One is ‘Yes’, will the formation of a tax consolidated group, of which the Taxpayer would be the head entity, result in the Taxpayer ceasing to carry on the business of money lending for the purposes of paragraph 25-35(1)(b) of the ITAA 1997?

Summary

No, the formation of a tax consolidated group will not mean that the Taxpayer ceases to carry on the business of lending money.

Detailed reasoning

When a consolidated group is formed it is governed by the single entity rule. Broadly this rule ensures that the head company and the subsidiary company are treated as a group. Section 701-1 of the ITAA 1997 states the following:

701-1(1) Single entity rule

If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period.

701-1(2) Head company core purposes

The purposes covered by this subsection (the head company core purposes) are:

(a) working out the amount of the head company's liability (if any) for income tax calculated by reference to any income year in which any of the period occurs or any later income year; and

(b) working out the amount of the head company's loss (if any) of a particular sort for any such income year.

701-1(3) Entity core purposes

The purposes covered by this subsection (the entity core purposes) are:

(a) working out the amount of the entity's liability (if any) for income tax calculated by reference to any income year in which any of the period occurs or any later income year; and

(b) working out the amount of the entity's loss (if any) of a particular sort for any such income year.

When a consolidated group is formed between the Taxpayer and Company A in the 20XX income year, these entities will be treated as a group, or a ‘single entity’ for income tax purposes.

It is possible that a subsidiary in a consolidated group may conduct different business activities from the head company and have entered into different transactions. In the current circumstances, the Taxpayer is conducting a money lending business in its own right and conducting a single project to protect its secured asset through the Company A subsidiary. Company A has been incorporated and put in place as a special purpose vehicle to generate significant revenue.

The question arises, however, whether the Taxpayer is still a money lender and whether the money lending activities have now become ancillary or incidental.

As per Bowen CJ in F.C. of T. v. Marshall and Brougham Pty Ltd 87 ATC 4522, when considering if a business of money lending is being carried on:

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in ones dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.

The Commissioner has considered whether the activity of the subsidiary Company A, which will give rise to substantial trading stock and revenue, results in the money lending activities of the Taxpayer being merely incidental such that money lending can no longer be said to be the primary business for the Taxpayer.

The Commissioner considers that the Taxpayer is still carrying on the business of money lending because its activities, although broadened, are more than ancillary or incidental. This is because of the following factors:

● The money earned from the money lending activities of the Taxpayer is still substantial.

● The business activity of the Taxpayer has not changed and the loan contracts entered by the Taxpayer are still on foot.

● The special purpose vehicle of Company A is temporary and only required until Company A’s project is complete.

The Taxpayer is still carrying on the business of lending money and this is its principal business that it conducts regardless of the Taxpayer creating a temporary subsidiary to secure one of its assets.

This will not be affected by the formation of the income tax consolidated group between the Taxpayer and Company A which means that the Taxpayer, as the head company, has the income tax reporting responsibility for the income tax consolidated group.

For completeness, it should be noted that once the Taxpayer and Company A form a consolidated group for income tax purposes:

● anything that has happened to Company A before it becomes a subsidiary of the Taxpayer are taken to be the actions and transaction of the Taxpayer as the head company (as per Taxation Determination TD 2005/23 Income tax: consolidation: can the head company of a consolidated group satisfy subsection 25-35(1) of the Income Tax Assessment Act 1997 in relation to a debt that is written off as bad by a subsidiary member, where the debt is in respect of money lent by the subsidiary in the ordinary course of its business of lending money before it became a member of the consolidated group?), and

● any loans (current or future) between the Taxpayer and Company A are disregarded for income tax purposes. Paragraph 6 of TD 2005/23 Income tax: consolidation: can the head company of a consolidated group satisfy subsection 25-35(1) of the Income Tax Assessment Act 1997 in relation to a debt that is written off as bad by a subsidiary member, where the debt is in respect of money lent by the subsidiary in the ordinary course of its business of lending money before it became a member of the consolidated group? (TD 2005/23) states:

6. This Tax Determination does not apply to an intra-group debt. An intra-group debt is one where the rights and obligations in respect of the debt are between members of the same consolidated group (for example, a loan between two group members). Intra-group debts are not recognised for income tax purposes during the period they are held within the consolidated group whether or not the debt, as a matter of law, was created before or during the period of consolidation (see Taxation Ruling TR 2004/11 paragraph 8(c)).

Question 3

Are the loans made by the Taxpayer to related parties excluded from the application of Division 7A of the ITAA 1936 pursuant to section 109M of the ITAA 1936?

Summary

The loans made to related parties will not be excluded from the application of Division 7A of the ITAA 1936 pursuant to section 109M of the ITAA 1936 as the loans to related parties are not made on the usual terms that the Taxpayer makes similar loans to unrelated/arm’s-length parties.

Detailed reasoning

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

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 lodgment 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.

Section 109M of the ITAA 1936 provides:

A private company is not taken under section 109D to pay a dividend because of a loan made:

a. in the ordinary course of the private company’s business; and

b. on the usual terms on which the private company makes similar loans to parties at arm’s length.

Section 109M of the ITAA 1936 contains two conditions, both of which must be satisfied. They are:

a. the loan must be made in the ordinary course of the private company’s business; and

b. the loan must be made on the usual terms on which the private company makes similar loans to parties at arm’s length.

a. Ordinary course of the private company’s business

The Commissioner has previously considered the issue of loans by private companies and ATO ID 2003/588 Income Tax Division 7A – loan in the ordinary course of business from a private company to an associated partnership treated as dividends (ATO ID 2003/588) can provide guidance on this issue.

ATO ID 2003/588 states:

Paragraph 109M(a) of the ITAA 1936 requires a loan to have been made in the ordinary course of the private company’s business and not in the ordinary course of business in general.

In ATO ID 2003/588, the transaction that occurred involved a private company and a partnership, both of which had the same members. The private company and the partnership had a loan agreement, and entered into a new loan agreement on similar terms.

Prior to this new loan, the only business that the private company engaged in was making loans and advancements to the partnership, with the private company not making any similar loans to arm’s length parties or entities.

As the business of the private company in ATO ID 2003/588 was advancing money to the partnership, the making of the loan to the partnership was in the ordinary course of the private company’s business, and paragraph 109M(a) of the ITAA 1936 was satisfied. However, ATO ID 2003/588 determined that the requirements in paragraph 109M(b) had not been satisfied because the private company had not made any loans to parties other than the partnership and consequently, section 109D of the ITAA 1936 applied to the loan.

The Taxpayer, in conducting its business, has made a number of loans to related parties in its particular industry for the purpose of enabling these borrowers to undertake projects. As a private company lending to non-corporates, Division 7A potentially applies.

These loans have been made over a number of years and are being made for the purpose of making a profit.

There were a number of non-arm’s length loans made in the last income year, and these loans were made in the ordinary course of business to non-corporate non-arm’s length parties for the purpose of making a profit within the broader family group.

The Taxpayer has provided an example of a loan agreement that the Taxpayer entered into with a non-arm’s length party on Division 7A terms. The Commissioner has reviewed this example loan agreement, and it is accepted that non-arm’s length party loans are being made in the ordinary course of the Taxpayer’s business.

As such, paragraph 109M(a) of the ITAA 1936 is satisfied.

b. The ‘usual terms’ on which the private company makes ‘similar loans’ to parties ‘at arm’s length’

Whether or not the loan from the private company to the shareholder satisfies the elements of paragraph 109M(b) of the ITAA 1936 requires an examination of the elements of paragraph 109M(b) of the ITAA 1936.

‘Usual terms’:

The meaning of the term ‘usual terms’ is considered in Taxation Determination TD 2008/1 Income tax: if a private company provides trade credit to a shareholder (or their associate) on the usual terms it gives to parties at arm’s length, will a failure by the shareholder (or their associate) to repay the amount within the agreed payment term prevent section 109M of the ITAA 1936 from applying? (TD 2008/1).

TD 2008/1 states at paragraph 18:

The usual terms are those terms under which the private company usually contracts.

The Taxpayer has submitted examples of (existing) loans provided to related and unrelated parties.

The Taxpayer, in conducting its business, has made loans to related and unrelated parties in its specific industry over a number of years. Based on the respective loan documentation for the above examples, the Commissioner considers that the Taxpayer’s related and unrelated party loans have usual terms in their lending documentation. This is particularly in respect to, for example, the interest rate, the loan period, whether repayment is required in full at the end of the loan period or by periodic repayments throughout the loan period, and the loan security.

However, the loans have differences in their usual terms given the context of the Taxpayer’s operations, being that:

● the related party loans have been put in place with particular terms to ensure that Division 7A requirements are met, and

● the unrelated party loans are tailored to each specific project.

‘Similar loans’:

ATO ID 2004/192 (withdrawn) Income Tax Division 7A: Loans made in the ordinary course of business on arm's length terms - treatment of current accounts (ATO ID 2004/192) and TD 2008/1, as referred to above, can provide guidance on this issue.

ATO ID 2004/192 states:

The word ‘similar’ is not defined for the purposes of section 109M of the ITAA 1936 and therefore adopts its ordinary meaning…. [Further], a comparison of the terms of loans made to parties at arm’s length is required to determine if the loans are similar.

TD 2008/1 states at paragraph 17:

For a loan to be similar there is no requirement that the loan be identical. However, the loan should be similar [to other loans] in terms of both documentation and conditions.

The ordinary meaning of ‘similar’ is defined in The Macquarie Dictionary (Third Edition, 1997) as ‘having likeness or resemblance, especially in a general way’.

‘Arm’s length’:

Parties will be at arm's length if neither party is able to exercise any control or influence over the other (Australian Trade Commission v WA Meat Exports Pty Ltd (1987) 75 ALR 287).

As provided in ATO ID 2003/588, section 109M of the ITAA 1936 only applies in circumstances where there are loans made by a private company to parties at arm's length. If loans are only made to parties not at arm's length (even though such loans may be made on arm's length terms), paragraph 109M(b) is not satisfied.

As noted above, the loans do have usual terms, but may still have differences in the conditions. The question is whether or not the loans are considered to be similar loans.

If the Taxpayer were to enter related party loans on usual terms, it needs to demonstrate that these will give an outcome that has similar documentation and conditions to those of loans to unrelated parties.

Based on a comparison of the terms in the example loan agreements supplied, while it is acknowledged that there are usual terms between the non-arm’s length (related) and arm’s length (unrelated) loans, the loans are considered to be individually tailored to such a degree that they would not be considered ‘similar’. In particular, the interest rate, use of a risk fee, and the security can vary considerably between the related and unrelated party loans.

In the current circumstances and based on the above analysis, the Commissioner is of the view that loans to related parties do not have similar loan documentation and conditions compared to unrelated party loans.

Therefore, paragraph 109M(b) of the ITAA 1936 is not considered to be satisfied.

As section 109M of the ITAA 1936 is not satisfied, loans made by the Taxpayer to related parties would not be excluded from the application of Division 7A of the ITAA 1936.

Question Four

If the answer to Question Three is ‘No’, would section 109M of the ITAA 1936 be satisfied such as to exclude loans from the application of section 109D of the ITAA 1936 should the terms of existing loans provided to related parties be modified, particularly in respect to the loan period, interest rate, regularity of repayments and nature of security held?

Summary

If the Taxpayer modifies the terms of its existing loans provided to related parties, particularly in respect to the loan period, interest rate, regularity of repayments and nature of security held, section 109M of the ITAA 1936 would be satisfied such as to exclude related party loans from the application of section 109D of the ITAA 1936.

Such an exclusion from the application of Division 7A in these circumstances would only have effect from the date upon which the terms on which its current (and future) loans with related parties are modified in line with the ‘template agreement’. The amendments to the current loan agreements for related party loans cannot apply retrospectively, and loans already in place before application of the new ‘template agreement’ will still be subject to Division 7A.

Detailed reasoning

Section 109M of the ITAA 1936, as iterated in the response to Question Three above, contains two conditions, both of which must be satisfied. They are:

a. the loan must be made in the ordinary course of the private company’s business; and

b. the loan must be made on the usual terms on which the private company makes similar loans to parties at arm’s length.

As per the Facts, the Taxpayer is proposing to modify the terms of the agreements under which it currently makes loans to related parties for the purpose of ensuring they include the usual terms on which the Taxpayer makes similar loans to unrelated parties. The Taxpayer has developed a ‘template agreement’ to reflect such modifications for loans to related parties going forward.

The Taxpayer proposes that, if the Commissioner is in agreement with the Taxpayer’s new ‘template agreement’ for loans to related parties:

● the terms of its current loans with related parties would be amended to terms consistent with those in the template, and

● future loans made to related parties would be entered into on terms consistent with those in the template.

a. Ordinary course of the private company’s business

As established in the response to Question Three, the Taxpayer has made a number of loans to both related and unrelated parties in the relevant industry in conducting its business. These loans have been made over a number of years and are being made for the purpose of making a profit.

The Taxpayer has provided an example of a modified loan agreement for loans to related parties, which is based on the new ‘template agreement’. The Commissioner has reviewed this example of a modified loan agreement, and it is accepted that non-arm’s length party loans made under this loan agreement are being made in the ordinary course of the Taxpayer’s business.

As such, paragraph 109M(a) of the ITAA 1936 is satisfied.

b. The ‘usual terms’ on which the private company makes ‘similar loans’ to parties ‘at arm’s length’

Each of the elements of paragraph 109M(b) of the ITAA 1936 have been defined and discussed in the response to Question Three above.

The example of a modified agreement for related party loans was compared to examples of existing agreements for unrelated party loans.

Based on this comparison, the Commissioner acknowledges there are usual terms between the non-arm’s length (related) and arm’s length (unrelated) loans – namely, the interest rate, loan period, repayment terms, the taking of a security, the use of a risk fee and the processes on default.

However, even if the loans have usual terms, they may still have differences in their respective conditions. The question is whether or not the loans are considered to be similar loans.

If the Taxpayer were to enter related party loans on usual terms, they need to demonstrate that these will give an outcome that has similar documentation and conditions to those of loans to unrelated parties.

Based on a comparative review of the loan documentation for each of the example loans, as well as the Taxpayer’s ‘template agreement’ outlined in the Facts, the Commissioner considers that a modified agreement for related party loans would be similar to loan agreements for unrelated parties in that:

● Interest rates:

● comprise both a lower rate and a higher rate

● are set by reference to the risk of each particular loan (not whether the borrower is related or unrelated)

● are applied in the same manner – that is, the lower rate applies unless there has been an event of default, otherwise the higher rate applies

● are calculated on a daily basis, and

● are paid at the end of the loan period along with the principal component of the loan.

● Loan period:

● differs for each project but is determined by reference to the period of the underlying project for which the loan is made, and

● is not a pre-determined fixed term (for example, seven years or 25 years) irrespective of the specific features of the loan, borrower, project etc.

● Repayments:

● are made at the end of the loan period, rather than throughout the period.

● Security:

● is always taken

● will vary depending on the specific risk of the loan, and

● will be subject to any pre-existing higher-ranking security.

● Process on default:

● Events of default are similar, if not the same, although time periods within certain steps may occur and extent of judgement debts may differ (but remain as requirements)

● Consequences of default are similar, if not the same, but particularly include:

● immediate termination of the loan, and

● principal and interest being immediately due and payable.

Further, this comparative review of the loan documentation for each of the above example loans found that, with respect to a number of other terms and conditions (other than the ‘usual terms’ above), the nature of these terms and conditions and their application were also generally similar. Any differences are considered minor/not critical to the application and operation of the loans.

Based on the above analysis, the Commissioner is of the view that, should the terms of the Taxpayer’s existing loan agreements for related party loans be modified as proposed in the Facts, such loans to related parties would have similar loan documentation and conditions compared to the loans that the Taxpayer provides to unrelated parties.

Therefore, should the loan agreements for related parties be modified as proposed, paragraph 109M(b) of the ITAA 1936 would be satisfied.

As section 109M of the ITAA 1936 would be satisfied in such circumstances, loans made by the Taxpayer to related parties would be excluded from the application of Division 7A of the ITAA 1936, particularly the deemed dividend implications of section 109D of the ITAA 1936.

Such an exclusion from the application of Division 7A in these circumstances would only have effect from the date upon which the terms on which its current (and future) loans with related parties are modified in line with the ‘template agreement’. The amendments to the current loan agreements for related party loans cannot apply retrospectively, and loans already in place before application of the new ‘template agreement’ will still be subject to Division 7A.

Question Five

Is the Taxpayer a financial institution for the purposes of the application of Taxation Ruling TR 94/32 with respect to non-accrual loans?

Summary

The Commissioner considers that the Taxpayer is not a financial institution for the purposes of the application of Taxation Ruling TR 94/32 with respect to non-accrual loans.

Detailed reasoning

Paragraph 2 of Taxation Ruling TR 94/32 Income Tax: non-accrual loans (TR 94/32) states that TR 94/32 applies to all taxpayers who come within the definition of a ‘financial institution’ as set out in Taxation Ruling TR 93/27 Income Tax: basis of assessment of interest derived and incurred by financial institutions (TR 93/27).

Paragraphs 14 to 23 of TR 93/27 provide guidance on the Commissioner’s view on the definition of a ‘financial institution’:

Definition of a 'Financial Institution'

14. The Australian Accounting Research Foundation discussion paper, 'Financial Reporting by Financial Institutions and Accounting for Financial Instruments', Discussion Paper No. 14 (1990) by Phillip Hancock, defines 'financial institutions' (at paragraph 1.03) to be:

'...any institution, one of whose principal activities is to take deposits and borrow, with the objective of lending and investing and includes all the following types of institutions:

Banks

Merchant banks

Finance companies

Building societies

Credit unions

Pastoral finance companies

Life insurance offices

General insurance offices

Pension and superannuation funds

Friendly societies

Cash management trusts

Co-operative housing schemes.'

15. However, in this Ruling a distinction is drawn between taxpayers that carry on business as financiers by taking deposits and borrowing funds and then on-lending or investing those funds for income earning purposes, and those taxpayers that invest substantial amounts of money as part of their income earning activity but do not finance their operations to any significant extent with borrowed funds. In the latter case funds are raised by way of equity or premiums which, by their nature, do not involve any interest expense. That is, borrowings play no, or only a limited, part in the business activities of the enterprise. The distinction is best illustrated by examining the difference between the operations of a bank and a building society compared with an insurance company.

16. The activities of a bank include accepting deposits from customers (with such deposits carrying interest); the payment of withdrawals on demand by customers; obtaining other funds by way of borrowing; and investing and lending deposited money and other borrowed funds. In Commercial Banking Co. of Sydney Limited v. F C of T (1950) 81 CLR 263 Dixon J (as he then was) discussed the activities of a trading bank. He concluded (at CLR 304) that:

'A banker's business may be said to be that of dealing in money.'

17. In Case P52 (1964) 14 TBRD 236; 11 CTBR (NS) 437 Case 75 Mr R.C. Smith (Member), after referring to these remarks of Dixon J, added (at TBRD 237; CTBR 439):

'...and in my opinion these words apply equally to the business of a savings bank as to that of a trading bank.'

18. In holding that the principal business of a bank was the lending of money, Dixon J in the Commercial Banking Co. of Sydney case said (supra at CLR 304):

'The profit-making side of his (a banker's) activities is in putting out the money so as to increase it, and that substantially means to obtain interest. If attention is riveted upon the relations of the banker to his customer and the amount of work done in that respect it might be thought that to say that the principal business consists of the lending of money is to ignore all the business done with customers whose accounts are in credit as well as much else besides. But if attention is riveted on the activities of banking in which the money is used or laid out it would seem correct to say that the decisively profit-making side of the business is concerned with the lending of money.' (Emphasis added).

19. Further, the No. 3 Board of Review in Case F26 74 ATC 132 at 155; (1974) 19 CTBR (NS) 291 Case 44 found that the investment operations of a building society and its day to day dealings with its customers were for all practical purposes indistinguishable from much of the business of a savings bank.

20. In F C of T v. Australian Mutual Provident Society (1953) 88 CLR 450 the High Court rejected the argument put by a mutual life assurance company that its principal business was the lending of money. In the following passage from the joint judgment of Dixon CJ, Williams, Fullager and Kitto JJ (at 463-4), their Honours illustrate the distinction between the business of a bank and an insurance company:

'In the Commercial Banking Co.'s Case it was held that the principal business of a bank was the lending of money. The Society maintains that its principal business also is the lending of money. The argument was, in our opinion, rightly rejected by the board. The Society's principal business is the business of life assurance, that is to say, the making and performance of contracts to pay, in consideration of premiums paid to it, sums of money on death or on the expiration of a period. Its business differs radically from that of a banker. The lending of money is of the essence of the business of a banker. He provides many other facilities for his customers, but it may be said to be the characteristic of his business that he borrows money in order to lend it. If he ceased to lend money, the nature of his business (assuming it to survive) would radically change. A life assurance company lends money, and its lendings are very important, but they are not the essence of its business. They are operations ancillary to the main business, made primarily because the holding of large funds to cover contingent liabilities is a necessity of that business. If a life assurance company ceased to lend money, the nature of its business would not change. The position would simply be that it would have to charge larger premiums in order to maintain itself in a sound position. Interest derived by a life assurance company on money lent by it is, in our opinion, income from property and not income from personal exertion. ' (Emphasis added)

21. Hence, a 'financial institution' for the purposes of this Ruling is a taxpayer that principally, and in the ordinary course of its business operations, derives assessable income by lending or investing funds obtained by way of deposit or borrowing. Generally speaking, taxpayers that are not moneylenders are excluded from the application of this Ruling.

22. Taxpayers that clearly fall within the restricted meaning of 'financial institution' used in this Ruling include banks, merchant banks, finance companies (including 'in-house' finance companies), building societies, credit unions and moneylenders. Taxpayers that do not fall within the restricted meaning of 'financial institution' used in this Ruling include insurance companies (both general and life), approved deposit funds, friendly societies and superannuation funds.

23. Some doubt may exist in particular cases as to whether this Ruling applies to a group holding company lending money to a subsidiary or other 'in-house' finance company. For the purposes of paragraph 63(1)(b) of the Act we accept that a moneylender need not necessarily be ready and willing to lend moneys to the public at large or to a wide class of borrowers. It would be sufficient if the taxpayer lends moneys to certain classes of borrowers provided it does so in a business-like manner with a view to yielding a profit from it. See generally paragraphs 42 to 46 of Taxation Ruling TR 92/18.

In the current circumstances, the Taxpayer is in the business of lending money, however it is not a traditional banking institution whose principal activities are to take deposits and borrow (from third parties and on market) with the objective of lending and investing. That is, the Taxpayer is not a savings bank or a trading bank.

Paragraph 23 of TR 93/27 provides that a group holding company may be a money lender for a narrow class of borrowers and also be considered a financial institution for the purposes of that ruling. However, given the other indicators of the Taxpayer’s business activity, the Commissioner does not believe that the Taxpayer is both a money lender and a financial institution.

In the Taxpayer’s case, these combined indicators are:

● no funds are obtained by way of deposit from customers

● no funds since 20XX have been obtained by borrowing from outside the group

● the only financial product being offered are loans

● the loans are only offered to a specific class of borrowers in a specific industry

● the Taxpayer is not a registered financial institution and does not intend to become registered, and

● the Taxpayer has no direct finance staff and utilises staff expertise and knowledge from other entities in the broader family group.

Therefore, on the basis of these collective indicators, the Commissioner considers that the Taxpayer is not a ‘financial institution’ for the purposes of TR 93/27 and TR 94/32.