Edited version of private advice

Authorisation Number: 1051519939819

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Date of advice: 20 May 2019

Ruling

Subject: Division 7A - debt forgiveness

Question

Will subsection 109G(4) of the Income Tax Assessment Act 1936 (ITAA 1936) apply, to treat any forgiveness of the Loan as not giving rise to a dividend?

Answer

No

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company made a loan (the Loan) to a related trust, (the Trust).

The Trustee of the Trust is X Pty Ltd (the Trustee). Y and Z are the directors of the Trustee and beneficiaries of the Trust.

The Trust then invested indirectly in residential investment properties, through loaning funds to other related trusts to cover property expenses.

Loan repayments and interest were paid to the Company in line with Division 7A requirements.

During the 20XX financial year, the properties were performing so badly that the decision was made for them to be sold.

The properties were acquired in mining areas and were sold making significant losses.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 109(G)(4)

Income Tax Assessment Act 1936 Section 109ZD

Income Tax Assessment Act 1936 Section 109ZE

Income Tax Assessment Act 1997 Section 960-100

Reasons for Decision

Under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) amounts paid, lent or forgiven by a private company to certain associated entities are treated as dividends, unless they come within specific exclusions.

The provisions apply where the recipient of the payment, loan or forgiven amount is a shareholder or an associate of a shareholder of the private company.

Under subsection 109F(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity (being a shareholder of or associate of a shareholder of the company) at the end of its year of income if all or part of a debt owed by the entity to the company is forgiven in that year.

The amount of the dividend equals the amount of the debt forgiven, subject to section 109Y of the ITAA 1936. However subsection 109G(4) of the ITAA 1936 provides that a private company will not be taken to pay a dividend in such circumstances if:

·         the debt was forgiven because payment of the debt would have caused the entity undue hardship;

·         when the entity incurred the debt, the entity had the capacity to pay the debt; and

·         the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity's control.

Undue hardship

The phrase 'undue hardship' is not defined in the ITAA 1936 and has not received judicial consideration in the context of Division 7A. Accordingly, it should be interpreted by having regard to its ordinary meaning, the statutory context in which the phrase appears and the object of the provision.

The Macquarie Dictionary defines hardship as:

A condition that bears hard upon one; severe, toil, trial, oppression or need.

In Re Wilson and Minister for Territories (1985) 7 ALD 225, the Administrative Appeals Tribunal considered the ordinary meaning of 'undue hardship'. Deputy President Hall described 'undue hardship' as hardship that is excessive in the circumstances, and something more than substantial hardship. This has been followed in subsequent decisions.

In the context of subsection 109G(4) of the ITAA 1936, hardship would necessarily involve a financial detriment resulting from the payment of the debt.

Trustees

Subsection 109G(4) of the ITAA 1936 does not make reference to either 'trust' or 'trustee'. Rather, it makes reference to an 'entity' which owes a debt to a private company.

Section 109ZD of the ITAA 1936 provides that 'entity' in Division 7A has the meaning given to it by section 960-100 of the Income Tax Assessment Act 1997 (ITAA 1997).

Section 109ZE of the ITAA 1936 provides that the interpretation rules contained in subsections 960-100(2), 960-100(3) and 960-100(4) of the ITAA 1997, also apply.

While subsection 960-100(1) of the ITAA 1997 includes a 'trust' within the concept of 'entity', the two notes to subsection 960-100(2) of the ITAA 1997 acknowledge that special provisions are needed for trusts as a result of the lack of separate legal personality inherent in the trust relationship. The effect of these provisions is that the 'office of trustee' is taken to be a separate entity. Accordingly, subsection 960-100(2) of the ITAA 1997 provides that the trustee of a trust is taken to be an entity 'consisting of the person who is the trustee, or persons who are the trustees, at any given time.'

By subsection 960-100(3) of the ITAA 1997, the legal personality acting as trustee is taken to be a separate entity in each capacity in which they operate - personally and as trustee of one or more trusts.

Trustees are personally liable for debts incurred in performance of the trust and may have corresponding rights of indemnity and exoneration. However, the statutory framework of section 109G of the ITAA 1936 and its reliance on section 960-100 of the ITAA 1997 makes it clear that, in the case of debts incurred by an entity acting as trustee, references to 'entity' for the purposes of the provisions are intended to refer the trustee in that capacity and not in its personal capacity.

The leading words of subsection 109G(4) of the ITAA 1936 refer to 'a debt owed by the entity'. This is a reference to an obligation (being the debt owed), meaning subsection 960-100(2) of the ITAA 1997 is necessarily enlivened and causes the reference to 'entity' to be a reference to the 'trustee' of the trust in respect of which the obligation was incurred, acting in that capacity.

Paragraph 109G(4)(a) of the ITAA 1936 also refers to 'entity' in testing the outcome if the debt was repaid. That is, whether the 'entity' would, in that event, suffer undue hardship. As a matter of statutory construction, the reference to 'entity' here must also be a reference to the same 'entity' contemplated by the leading words of subsection 109G(4) of the ITAA 1936.

It follows from the statutory scheme that the relevant hardship referred to in subsection 109G(4) of the ITAA 1936 is to be tested in relation to the trustee in its capacity as trustee and not in its personal capacity.

Can a trustee suffer hardship due to the payment of a debt?

Payment of a debt would not result in a financial detriment to a trustee if trust assets exceed trustee liabilities.

While trustees are personally liable for debts incurred in performance of the trust, they may have corresponding rights of indemnity and exoneration. These rights take priority over the beneficiaries' interests in trust assets so that a beneficiary's entitlement at any point in time is to the assets that are remaining after the trustee's rights to indemnity and exoneration have been exercised.

Because in such circumstances trustees have recourse to trust assets before distribution to beneficiaries, trustees will always be able to exercise their rights to indemnity and exoneration in discharging trust debts where trust assets exceed trust liabilities. Accordingly, where trust assets exceed liabilities, a trustee cannot suffer any financial detriment, on the payment of a trust debt. It follows there can be no 'hardship' in terms of what is contemplated by paragraph 109G(4)(a) of the ITAA 1936.

However, where liabilities exceed trust assets and the trustee's liability is not limited, the trustee's personal assets may be exposed to repay trust debts without effective recourse through their rights to indemnity and exoneration. Where the trustee's personal assets are so exposed, it might be argued that payment of a debt could, in those circumstances, cause a financial detriment. In any event, the detriment, if it exists in those circumstances, would be to the trustee personally, and as such to a separate entity, different from the entity which is the focus of subsection 109G(4) of the ITAA 1936.

The operation of section 960-100 of the ITAA 1997 leads to the result that a trustee, as trustee, could not suffer undue hardship within the meaning of paragraph 109G(4)(a). The analysis applies equally to individual or incorporated trustees.

Conclusion

In this case the Company made the Loan to the Trustee. For subsection 109G(4) of the ITAA 1936 to apply, the Commissioner must be satisfied that payment of the debt would cause the Trustee undue hardship.

The entity in this case that may endure undue hardship is a separate legal entity to the Trustee. Accordingly, subsection 109G(4) of the ITAA 1936 will not apply to treat any forgiveness of the Loan as not giving rise to a dividend.