Edited version of private advice

Authorisation Number: 1051799201069

Date of advice: 11 February 2021

Ruling

Subject: Family provision order and notional estate order on a private company - Division 7A

Question

Will a payment made by Company A to you, pursuant to a family provision order and a notional estate order, be a deemed dividend under Division 7A of the Income Tax Assessment Act 1936?

Answer

Yes

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

Relevant facts and circumstances

Your parent (the Deceased) passed away.

You commenced proceedings against the executor of the estate of the Deceased (the Estate).

You have sought orders on the construction of a gift made in the will of the Deceased (the Will), and further orders under Chapter 3 of the Succession Act 2006 (NSW) (the Succession Act), for further and alternative provision out of the estate or the notional estate.

The Will provided for a gift to you of a property.

The property was not owned by the Deceased at the date of death but, was owned by Company A (the Company). The purported gift under the Will therefore failed.

Under the Will the residuary of the Estate (including all shares) was left to your relative.

The Deceased was the sole shareholder and one of two directors (the other being your relative) of the Company.

Your relative is currently the sole shareholder of the Company.

The Property was sold and the proceeds are held by solicitors on behalf of the Company. Capital gains tax is payable by the Company in respect of this transaction.

You are seeking an order of notional estate of the Deceased (under section 80 of the Succession Act), and that the Company must pay these proceeds to you pursuant to a family provision order (under section 59 of the Succession Act).

It is expected that the accounting treatment of the payment, in the books of the Company, will be:

DR Compensation Payment (Abnormal Expense)

CR Cash

Assumptions

That the court will make a notional estate order and order the Company to make a payment to you pursuant to a family provision order.

Relevant legislative provisions

Section 44 of the Income Tax Assessment Act 1936

Section 109C of the Income Tax Assessment Act 1936

Section 109J of the Income Tax Assessment Act 1936

Section 109Y of the Income Tax Assessment Act 1936

Section 109ZD of the Income Tax Assessment Act 1936

Section 318 of the Income Tax Assessment Act 1936

Reasons for decision

A family provision order may be made in relation to property that is not part of the deceased's estate but is designated as "notional estate" of the deceased person by an order under Pt 3.3 of the Succession Act under subsection 63(5) of the Succession Act.

A "notional estate" of a deceased person is defined in section 3(1) of the Succession Act to mean property designated by a notional estate order as notional estate of the deceased person. "Notional estate order" means an order made by the Court under Chapter 3 of the Succession Act, designating property specified in the order as notional estate of a deceased person. A person's rights are extinguished to the extent that they are affected by a notional estate order under section 84 of the Succession Act.

On the facts, it is established that if the court grant the orders as requested the Company will have an obligation to pay you the total amount under the family provision order.

Application of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936)

Division 7A of ITAA 1936 operates to treat payments, loans, and forgiven debts of a company to a shareholder or an associate of a shareholder as a dividend, and therefore assessable income, under section 44 of the ITAA 1936. It is intended to have broad application and its application is limited only to the extent of specific exceptions and exclusions.[1]

Relevantly, section 109C of the ITAA 1936 provides:

A private company is taken to pay a dividend to an entity at the end of the private company's year of income if the private company pays an amount to the entity during the year and either:

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

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

Section 109ZD of the ITAA 1936 provides that 'associate' has the meaning provided in section 318 of the ITAA 1936. Paragraph 318(a) of the ITAA 1936 provides that a relative of a natural person is an associate of that person. You are an associate of your relative, and as your relative is the sole shareholder of the Company, you are therefore an associate of a shareholder.

In this case the Company would be making a payment to a shareholder's associate (you) and will be taken to have paid a dividend under subsection109C(3) of the ITAA 1936 unless a specific exception or exclusion applies.

Could the payment made to you by the Company be a payment discharging pecuniary obligations and, therefore, not treated as dividends pursuant to section 109J of the ITAA 1936?

Section 109J of the ITAA 1936 provides an exception to a deemed dividend arising under Division 7A for payments of genuine debts. To the extent that the payments made to you discharge an obligation of the Company to pay money to you (paragraph 109J(a) of the ITAA 1936) and the payments are not more than would have been required to discharge the obligation had the parties been dealing with each other at arm's length (paragraph 109J(b) of the ITAA 1936), the Company would not be taken to have paid dividends to you under section 109C of the ITAA 1936. These two factors are discussed below.

•         Would the payment to you under a family provision order be considered a 'discharge' of an obligation for the purposes of paragraph 109J(a) of the ITAA 1936?

Taxation ruling TR 2014/5 Income Tax: matrimonial property proceedings and payments of money or transfers of property by a private company to a shareholder (or their associate) (TR 2014/5) provides the Commissioners view on the tax treatment of payments made in accordance with a family court order made under section 79 of the Family Law Act 1975, and states the following on requirements of section 109J:

90. Where the private company is made party to the proceedings such that the Family Court can impose orders directly on the private company, any subsequent order of the Family Court under section 79 of the FLA 1975 for a private company to pay money to an associate of a shareholder imposes a binding requirement in law for the payment to be made. This type of obligation is 'an obligation of the private company to pay money to an entity' in terms of paragraph 109J(a) of the ITAA 1936. Where a private company makes a payment to an associate of the shareholder in compliance with the obligation imposed by the order of the Family Court, this constitutes a 'discharge' of that obligation for the purposes of paragraph 109J(a).

On the facts, it is established that if the court grant the orders as requested, the Company will have an obligation to pay you the total amount under the family provision order.

•         Were you and the Company dealing at arm's length for the purposes of paragraph 109J(b)of the ITAA 1936?

The Supreme Court exercises its own discretion on whether to make an order, and, if so what orders to make, even if orders are sought by consent. Family provision orders are therefore not the outcome of negotiation between the parties. Such orders do not therefore involve a dealing in the relevant sense between the private company and the associate of the shareholder.

In determining what a private company is obliged to pay to a non-shareholder, outside the family law setting, paragraphs 111 - 114 of TR 2014/5 state:

111. In a commercial setting, for a private company to make a payment to a non-shareholder, the payment would ordinarily need to be in consideration for something of value provided in return by the non-shareholder.

112. Even if the private company is empowered to make gratuitous payments to non-shareholders, this does not answer the question of what arm's length amount the Company would be obliged to pay. The essence of a gratuitous payment is a voluntary appropriation of cash or property to a donee, that is, a gift. A gift involves no imposition of any obligation on the donor nor any discharge of an obligation in the making of the gift.

113. In view of the foregoing, the Commissioner considers there is no identifiable circumstance under which a private company might make a gratuitous appropriation of profits to a non-shareholder in discharge of an obligation in an arm's length dealing as required by the test in paragraph 109J(b) of the ITAA 1936. Therefore, any payment made in compliance with an order of the Family Court under section 79 of the FLA 1975 necessarily exceeds what would be paid in an arm's length dealing. Accordingly, section 109J will not apply to prevent such a payment from being treated as a deemed dividend under section 109C of the ITAA 1936.

114. Concluding that arm's length parties would not enter into a relevant transaction at all (so that transaction necessarily exceeds what would have occurred between arm's-length parties) is not novel. In Allen & Anor (as trustees for Allen's Asphalt Staff Superannuation Fund) v. FC of T, which concerned the former paragraph 273(7)(b) of the ITAA 1936 Collier J held:

Had the parties been at arm's length, there is no evidence before me to support a finding that the arrangement would have occurred at all and that the Super Fund would have derived the income it received. It follows that the amount of relevant income received by the Super Fund was greater than might have been expected to have been received if the parties had been dealing with each other at arm's length.

This reasoning would apply equally to the succession law setting, and as such, the requirement in paragraph 109J(b) of the ITAA 1936 would not be satisfied.

The argument that a family provision order is closer to a court order for compensation for negligence and therefore section 109J of the ITAA 1936 would apply as discussed in Note 17 of TR 2014/5EC does not apply on the facts. Note 17 of TR 2014/5EC relevantly states:

On these facts, an alternate hypothesis can be constructed to satisfy the requirements of paragraph 109J(b) of the ITAA 1936. In the alternative to proceeding to trial, the parties might settle the matter out of Court.

In such circumstances an equivalent amount might be expected to be agreed. The benefits of settlement are as usual the savings to both parties in terms of the time and costs of litigation.

The agreement to settle would impose an enforceable obligation in contract on the private company. This is because consideration passes in respect of the promises made by both parties. In the case of the injured party, it is the forbearance to pursue the cause of action in tort that represents the necessary consideration.

Whether paragraph 109J(b) is satisfied in any particular case is ultimately a matter to be decided having regard to the facts of each case.

Unlike a compensation claim however, a party to a family provision order does not have an alternative avenue for settling their claim. Where the Will does not provide for the applicant, an Estate can only make a payment to a party in the event of a successful family provision claim.

As both elements of section 109J of the ITAA 1936 are not satisfied the provision will not operate to prevent the payment from being treated as a dividend under section 109C of the ITAA 1936 per the ATO view in TR 2014/5.

Subsection 109C(2) of the ITAA 1936 provides that the amount of the dividend will be the amount paid, subject to the private company's distributable surplus calculated under section 109Y of the ITAA 1936.

[1] Paragraphs 9.1 and 9.2 of the Explanatory Memorandum to Tax Law Amendment Bill (No 7) 1997.