Edited version of private advice

Authorisation Number: 1051731851687

Date of advice: 07 August 2020

Ruling

Subject: Division 7A

Question 1:

Does section 109T of the Income Tax Assessment Act 1936 (ITAA 1936) apply so that Company A is taken to have made payments or loans to individual X?

Answer:

No

Question 2:

Will the amount of the deemed dividend arising under section 109E of the ITAA 1936 due to X's failure to make the minimum yearly repayment for the 2020 income year be reduced to nil due to section 109Y of the ITAA 1936?

Answer:

Yes. The principal component of the minimum yearly repayment does not reduce the amount of the loan not repaid by the end of the 2020 income year.

This ruling applies for the following period:

1 July 2019 - 30 June 2020

The scheme commences on:

1 July 2019

Relevant facts and circumstances

Company A and Company B are in a consolidated group for income tax purposes with Company A as the head entity.

Individual X owns all the issued shares in Company A.

When Company B was established it borrowed an amount from Company A to fund the purchase of a property (Property). It continued to borrow from Company A to fund its business operations.

Company B's business activities were conducted at the Property.

There is no loan agreement between Company A and Company B and no repayment has been made.

In 2018 Company B sold the Property and ceased its business activities. In the same year it made a loan to X. The amount of this loan was approximately a third of the balance of the loan from Company A to Company B.

A loan agreement between Company B and X (Agreement) was executed when the loan was taken out. The term of the loan is for a maximum period of seven years commencing from 30 June 2018.

The interest rate is specified as being not less than the benchmark interest rate as defined under subsection 109N(2) of the ITAA 1936.

A minimum yearly repayment was made by X in the 2019 income year.

The minimum yearly repayment for the 2020 income year was $xxx consisting of principal and interest.

X has failed to make the repayment as he was not financially able to do so.

X has decided not to request the Commissioner to grant an extension of time to make the minimum yearly repayment for the 2020 income year due to the COVID-19 situation.

The Commissioner has not been provided with any evidence that the failure to pay was beyond X's control and X would suffer undue hardship if a deemed dividend would arise.

The amount of Company B's liabilities is greater than its assets. Its paid up share value is $1 and there are no Non-commercial loans and Repayments of non-commercial loans.

There are no other transactions that would have a consequence under Division 7A of the ITAA 1936 in the 2020 income year.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 109E

Income Tax Assessment Act 1936 subsection 109E(1)

Income Tax Assessment Act 1936 subsection 109E(2)

Income Tax Assessment Act 1936 subsection 109E(5)

Income Tax Assessment Act 1936 subsection 109E(6)

Income Tax Assessment Act 1936 section 109F

Income Tax Assessment Act 1936 subsection 109G(3A)

Income Tax Assessment Act 1936 subsection 109G(3B)

Income Tax Assessment Act 1936 section 109N

Income Tax Assessment Act 1936 section 109N(1)

Income Tax Assessment Act 1936 section 109N(2)

Income Tax Assessment Act 1936 section 109T

Income Tax Assessment Act 1936 subsection 109T(1)

Income Tax Assessment Act 1936 section 109Y

Income Tax Assessment Act 1936 subsection 109Y(1)

Income Tax Assessment Act 1936 section 109Y(2)

Income Tax Assessment Act 1936 section 318

Income Tax Assessment Act 1936 sub-subparagraph 318(2)(d)(ii)(A)

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1936 unless otherwise stated.

Question 1

Summary

Section 109T does not apply with respect to the loans from Company A to Company B and the loans from Company B to X.

Detailed reasoning

Subdivision E of Division 7A extends the application of Division 7A to certain arrangements where a private company makes a payment or a loan to an entity interposed between the private company and a shareholder of the private company or an associate of the shareholder (target entity), and the interposed entity makes a payment or loan to the target entity.

Under subsection 109T(1), Subdivision E applies if a reasonable person would conclude, having regard to all the circumstances, that the private company made the payment or loan solely or mainly as part of an arrangement involving a payment or loan to the target entity. If a private company makes a payment or a loan to an interposed entity and the interposed entity makes a payment or loan to a target entity in such circumstances, the private company is taken to have made the loan or payment directly to the target entity.

We have considered the circumstances surrounding the loans from Company A to Company B as well as the loans from Company B to X in 2018 and concluded that Company A did not make the loans to Company B solely or mainly as part of an arrangement involving Company B making the loans to X in 2018.

Question 2

Summary

Company B is taken to pay a dividend to X under section 109E when X failed to make the minimum yearly repayment for the 2020 income year. The amount of the dividend is reduced to nil as Company B had no distributable surplus in this year. The principal component of the shortfall for the 2020 income year will be taken into account in calculating the minimum yearly repayment for the 2021 income year.

Detailed reasoning

A payment or benefit provided by a private company to a shareholder or an associate of a shareholder can be treated as a dividend under Division 7A even if the payment takes the form of a loan, advance, gift or forgiveness of a debt. Division 7A generally applies to amounts paid, lent or forgiven on or after 4 December 1997.

'Associate' is defined in section 995-1 of the Income Tax Assessment 1997 (ITAA 1997) to have the meaning given by section 318.

In this case, Company A is the shareholder in Company B. X is an associate of Company A in accordance with sub-subparagraph 318(2)(d)(ii)(A) because X holds all voting interest in Company A. Accordingly, X is an associate of the shareholder of Company B.

The loan made by Company B to X, therefore, is within the scope of Division 7A.

Under section 109E, a shareholder, or an associate of the shareholder, who has received a loan or loans from a private company must make a specified minimum yearly repayment in relation to the loan or loans. A deemed dividend may arise under subsection 109E(1) if the private company does not receive the minimum yearly repayment worked out in accordance with subsection 109E(5) using the formula under subsection 109E(6). Under subsection 109E(2), the amount of the deemed dividend is subject to section 109Y.

X has failed to pay the minimum yearly repayment for the income year 2020. Section 109Q is not relevant as the Commissioner has not been provided with any evidence that the failure to pay was beyond X's control and X would suffer undue hardship if a deemed dividend would arise. Accordingly, under subsection 109E(1) Company B is deemed to have paid X a dividend, the amount of which is subject to the distributable surplus under section 109Y.

The amount of a dividend that a private company can be deemed by Division 7A to pay in an income year is limited to the company's distributable surplus in that year. In accordance with Taxation Determination TD 2004/68 Income tax: consolidations: Division 7A: if a private company that is a head company or subsidiary member of a consolidated group makes a payment or a loan, or forgives a debt to a shareholder (or shareholder's associate) external to the consolidated group, does the single entity rule apply to the calculation of the distributable surplus under section 109Y of the Income Tax Assessment Act 1936 ? (TD 2004/68), although Company B is a member of a consolidated group the single entity rulein section 701-1 of the ITAA 1997 does not apply to the calculation of the distributable surplus under section 109Y. Paragraph 1 of TD 2004/68 states that only the accounts of the private company (that is the head company or the subsidiary member), that is treated as having paid a dividend under Division 7A to the shareholder or shareholder's associate external to the consolidated group, are relevant in calculating the distributable surplus under section 109Y.

Therefore, for the purpose of determining the amount of the dividend that arises under section 109E, Company B's distributable surplus is calculated according to the formula under subsection 109Y(2) as follows:

Distributable surplus = Net assets + Division 7A amounts - Paid up share value

'Net assets' is an amount, if any, by which Company B's assets, according to its accounting records, exceed the sum of its present legal obligations.

For the 2020 income year, the amount of liabilities exceeds assets, the 'Net asset' is considered to be nil for the purpose of the formula under subsection 109Y(2).

'Division 7A amounts' is the total of any amounts of any deemed dividends that arise under sections 109C and 109F. As Company B is not taken to have paid a dividend under these sections the 'Division 7A amounts' is nil.

As the 'Paid up share value' amount is $1, Company B does not have a distributable surplus.

Conclusion:

The amount of the dividend that has arisen under subsection 109E(1) is reduced to nil in accordance with subsection 109E(2).

However, where a shortfall in a minimum yearly repayment gives rise to a deemed dividend under section 109E, the principal component of the shortfall does not reduce the 'Amount of the loan not repaid by the end of the previous year of income' in the formula in subsection 109E(6) when calculating the minimum yearly repayment for the subsequent income year, in accordance with ATO ID 2013/36 Income Tax Division 7A: capital component of shortfall in minimum yearly repayment and the 'Amount of the loan not repaid by the end of the previous year of income' in the formula for the minimum yearly repayment in section 109E of the Income Tax Assessment Act 1936.

Therefore, the principal amount of the shortfall for the 2020 income year will be taken into account in calculating the minimum yearly repayment for the 2021 income year.

The total shortfall amount for the 2020 income year remains as an outstanding debt with Company B. X can either make the shortfall payment or Company B can forgive that amount of the debt in a later income year. If Company B forgives the debt, the debt forgiveness will be subject to a deemed dividend under section 109F. As Company B has been taken under section 109E to pay a dividend to X in an earlier income year, the amount of the dividend under section 109F in a later income year would be reduced by the amount of the dividend under section 109E (subsections 109G(3A) and 109G(3B)). In this case, as the amount of the dividend under section 109E is nil as explained above, the amount of the reduction under subsection 109G(3B) is nil.