Edited version of private advice

Authorisation Number: 1052059281773

Date of advice: 30 November 2022

Ruling

Subject: Tax integrity measures

Question

Are any of the amounts (or part thereof) paid during the year of income ended 30 June 20yy by X Pty Ltd to partly repay a loan owing by X Pty Ltd to the taxpayers deemed under Subdivision E of Division 7A to be, for the purpose of Division 7A, payments made by Z Pty Ltd to the taxpayer by reason of there also being amounts loaned by Z Pty Ltd to X Pty Ltd during that year of income?

Answer

No.

This ruling applies for the following period:

1 July 20xx to 30 June 20yy

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

X Pty Ltd

1.    Mr A, and his siblings, Mrs B, Mrs C and Mr D each have a 25% legal and beneficial interest in the private company X Pty Ltd.

2.    The directors of X Pty Ltd are Mr A, Mr D and Mrs B.

3.    X Pty Ltd conducted several businesses during the period from the late 1980's until about 20aa. Following the sale of it's businesses, X Pty Ltd invested the sale proceeds in a conservatively structured portfolio of equities and property.

4.    For many years X Pty Ltd paid substantial dividends to its shareholders each year.

Sale of Construction Business and Commercial Property

5.    Mr A and his siblings benefited from sale of a business and a commercial property. The business was held by the siblings in their own names while the commercial property was held in a unit trust for their benefit.

6.    Following the sale of these assets, Mr A and his siblings received sufficient funds such that it has not been necessary in recent years for X Pty Ltd to declare dividends to them on a joint basis.

Investment strategy of X Pty Ltd

7.    As a result of reduced need for X Pty Ltd to declare dividends to its shareholders, the company pursued its long-term investment strategy for the after-tax proceeds of the sale of its businesses.

8.    A funds management team was employed by X Pty Ltd to protect and build the company's assets with a view to providing a heritage for future generations.

9.    Being mindful of the intergenerational objectives of X Pty Ltd, the directors of X Pty Ltd have instructed X Pty Ltd's funds management team to develop an investment strategy that gave a priority to protecting X Pty Ltd's assets.

10.  Because of this policy, in the period during which Australian's economy (and other world economies) were experiencing difficulties arising from Covid-19 encouraged economic lockdowns, X Pty Ltd's funds management team exited high risk investments and built cash balances.

Z Pty Ltd

11.  Mr A has approximately 80% legal and beneficial interest in Z Pty Ltd. The other approximate 20% ownership of the company is held by his spouse Mrs A.

Loans from the Mr A to Z Pty Ltd and other related entities:

12.  Mr A used some of his portion of the after-tax proceeds from the sale of the business and the commercial property to attend to his family's longer term estate planning with the excess being transferred to his private companies via loans, in particular to Z Pty Ltd.

13.  No documented loan agreements exist between Mr A and Z Pty Ltd or between Mrs A and Z Pty Ltd, as they were never considered necessary. The loans between the taxpayers and Z Pty Ltd are interest-free, unsecured and repayable on demand.

Declaration of dividends by Z Pty Ltd

14.  On 1 July 20xx, Z Pty Ltd declared a total dividend of $x,xxx,xxx of which $x,xxx,xxx (80%) was due to Mr A and $x,xxx,xxx (20%) was due to Mrs A. The taxpayers included the dividends of $x,xxx,xxx and $x,xxx,xxx together with the associated franking credits in their income tax returns for the year ended 30 June 20yy. The dividends were not paid at the time they were declared but rather they were credited to the account in favour of the taxpayers on 1 July 20xx.

$20 million loan facility provided by X Pty Ltd (as lender) to Z Pty Ltd (as borrower)

15.  Over time, X Pty Ltd's shareholders' approached the directors of the company to request access to some of the profits retained in X Pty Ltd to independently seek investments with a higher risk profile, but which promised higher returns for accepting that higher risk. The directors of X Pty Ltd agreed to this request.

16.  Each of the shareholders has a separate private company that they and their immediate families control for the purpose of building their own family's independently from their siblings. X Pty Ltd granted each of these four separate private companies a $xx million loan facility to be drawn at times and amounts at the options of each company independently of each other.

17.  Relevant to the taxpayers, on 28 June 20yy, Z Pty Ltd (as borrower) entered into a $xx million loan facility with X Pty Ltd (as lender). The loan facility is unsecured but subject to a rate of interest set at a rate beneficial to X Pty Ltd when compared to the rate X Pty Ltd could achieve on cash holdings (including term deposits). The rate being roughly the midpoint between arm's length borrowing rates and arm's length deposit rates. Initially this rate was x.xx% for the year ended 30 June 20yy.

Amounts paid/received by Z Pty Ltd to/from the taxpayers

18.  During the year ended 30 June 20yy, the taxpayers made payments to and drew money from Z Pty Ltd. A summary of the movements is set out below:

19.  During the year of income ended 30 June 20yy, Z Pty Ltd drew down $x million of its $xx million facility with X Pty Ltd and then repaid $x million to the taxpayers as a part repayment of the amounts owing to him. The draw down by Z Pty Ltd from X Pty Ltd allowed Z Pty Ltd to meet the request from the taxpayers to reduce the amounts owing to them (including the assessable 1 July 20xx dividend) without the liquidation of some of Z Pty Ltd's investments that Z Pty Ltd wished to retain.

20.  Z Pty Ltd was and is of the view that this drawdown was consistent with and met the stated purpose of the loan facility, that purpose being to allow Z Pty Ltd to invest in investments with a higher risk/reward profile. That the drawdown allowed Z Pty Ltd to retain its existing investments as opposed to undertaking new investment was consistent with the purpose of the loan facility.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 103A

Income Tax Assessment Act 1936 Section 109C

Income Tax Assessment Act 1936 Section 109D

Income Tax Assessment Act 1936 Section 109J

Income Tax Assessment Act 1936 Section 109K

Income Tax Assessment Act 1936 Section 109T

Income Tax Assessment Act 1936 Section 109V

Income Tax Assessment Act 1936 Subsection 109V(1)

Income Tax Assessment Act 1936 Subsection 109V(2)

Income Tax Assessment Act 1936 Subsection 109W

Income Tax Assessment Act 1936 Section 109X

Income Tax Assessment Act 1997 Subsection 318(1)

Reasons for decision

DISTRIBUTIONS TO ENTITIES CONNECTED WITH A PRIVATE COMPANY - DEEMED DIVIDENDS

21.  Broadly, Division 7A of Part III of the ITAA 1936[1] (Division 7A) is an integrity measure aimed at ensuring that profits of a private company are not effectively received by its shareholders in non-dividend form. The general provisions of Division 7A apply to treat amounts paid, lent, or debts forgiven, by a private company to a shareholder of a private company, or an associate of such a shareholder, as unfranked dividends, unless they come within specified exclusions.

Definition of a 'private company'

22.  A private company is defined in subsection 103A(1) as a 'company [that] is not a public company in relation to the year of income.' According to subsection 103A(2), a public company includes:

a.    a company whose shares were listed for quotation on a stock exchange at the last day of the income year

b.    a co-operative company, mutual life assurance company or friendly society dispensary

c.     a company that has not been carried on for the purpose of profit or gain to its members and was prohibited by its constitution from making a distribution to its members

d.    a government body or a company controlled by a government body, and

e.    a subsidiary of a public company.

23.  As X Pty Ltd does not satisfy the criteria of a public company, it is a private company in accordance with subsection 103A(1).

Definition of 'associate'

24.  For the purposes of Division 7A, section 109ZD defines associate to have the meaning given by section 318.

25.  An associate for Division 7A purposes has the meaning given by section 318 and generally includes your relatives; a partnership that you are a partner in; a trustee of a trust that you, or your associate, are a beneficiary of; or a company that you, or your associate, control or influence.

Payments, loans and debt forgiveness treated as dividends

26.  Section 109C provides that a private company is taken to pay a dividend to an entity if the private company pays an amount to the entity during the year and the entity is a shareholder in the private company (or an associate of the shareholder) or it is reasonable to conclude that the payment is made because the entity was a shareholder or associate at some time.

27.  Subsection 109C(3) provides that a payment to an entity is:

a.    a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and

b.    a credit of an amount to the extent that it is:

(i)       to the entity; or

(ii)      on behalf of the entity; or

(iii)     for the benefit of the entity; and

c.     a transfer of property to the entity.

28.  Section 109D provides that a private company is taken to pay a dividend to an entity if the private company loans an amount to the entity during the year that is not fully repaid before lodgement date and the entity is a shareholder in the private company (or an associate of the shareholder) or it is reasonable to conclude that the payment is made because the entity was a shareholder or associate at some time.

29.  Subsection 109D(3) provides that a 'loan' to an entity is:

(a)  an advance of money; and

(b)  a provision of credit or any other form of financial accommodation; and

(c)   a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and

(d)  a transaction (whatever its terms or form) which in substance effects a loan of money.

Payments and loans that are not treated as dividends

30.  Subdivision D of Division 7A sets out the circumstances when loans and payments made by a private company are not treated as deemed dividends. One such exclusion is section 109K, which provides that a private company is not taken to pay a dividend under sections 109C or 109D because of a loan it makes to another company.

31.  Section 109J further provides that where a payment discharges an obligation of the private company to pay money to an entity, and the payment is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm's length, a deemed dividend would not arise under section 109C. However, section 109J applies only in respect of loans made by the private company to their shareholder or their associates, and not where the funds are subsequently on-lent.

Payments and loans through interposed entities

32.  Where the private company provides a loan or payment to another entity (an interposed entity), such as a company, and that loan or payment is used by the interposed entity to make a payment or loan to a shareholder of the private company (the target entity) the interposed entity rules contained in Subdivision E of Division 7A (sections 109T to 109X) could apply. In this circumstance, the interposed entity provisions broadly provide that the private company may be taken to have paid a dividend, pursuant to Subdivision B, to the target entity such that this dividend is to be included in the assessable income of the shareholder under section 44.

Meaning of the term 'entity'

33.  Section 109ZD provides that the meaning of 'entity' is that pursuant to section 960-100 of the Income Tax Assessment Act 1997 (ITAA 1997). Section 960-100 of the ITAA 1997 states that an entity includes an individual, a body corporate, a body politic, a partnership, any other unincorporated association or body of persons, a trust, a superannuation fund or an approved deposit fund.

Payments or Loans through Interposed Entities - Section 109T

34.  Subsection 109T(1) provides that a private company is taken to have made a payment or loan to a target entity for the purposes of Division 7A if:

(a)       the private company makes a payment or loan to an entity (the first interposed entity)

(b)       a reasonable person would conclude that the private company made the payment or loan solely or mainly as part of an arrangement involving a payment or loan to a target entity, and

(c)       either:

(i)        the interposed entity then makes a payment or loan to the target entity, or

(ii)       another entity interposed between the private company and the target entity makes a payment or loan to the target entity.

35.  Guidance on the Commissioner's application of paragraph 109T(1)(b) is found in Taxation Determination TD 2011/16: Income Tax: Division 7A - payments and loans through interposed entities - factors the Commissioner will tax into account in determining the amount of any deemed payment or notional loan arising under section 109T of the Income Tax Assessment Act 1936 (TD 2011/16).

36.  Paragraph 34 of TD 2011/16 explains that all that is required to satisfy paragraph 109T(1)(b) is for a reasonable person to conclude that the payment or loan from the private company to the interposed entity was part of an arrangement involving a payment or loan to the target entity (a back-to-back arrangement). It further states that although there is no requirement to demonstrate that a purpose of the arrangement was to avoid Division 7A, 'such a purpose or intent may help establish such a reasonable conclusion'.

37.  Tax Determination TD 2018/13 Income tax: Division 7A: can section 109T of the Income Tax Assessment Act 1936 apply to a payment or loan made by a private company to another entity (the 'first interposed entity') where that payment or loan is an ordinary commercial transaction? (TD 2018/13) states the following:

66. In particular, subsection 109T(1) provides that a private company will be taken to make a payment or loan to the target entity where a reasonable person would conclude (having regard to all the circumstances) that the private company made the payment or loan to the first interposed entity, solely or mainly, as part of an arrangement involving a payment or loan through one or more interposed entities to the target entity.

67. If the outcome of the arrangement is that the target entity would effectively receive a tax-free distribution from the private company (but for the application of Subdivision E of Division 7A), the arrangement properly falls for consideration under Subdivision E of Division 7A (subject to the exclusion in subsection 109T(3)). This would be so regardless of the intention of the parties to the arrangement, given the intended purpose of Division 7A⁶.

38.  In addition, footnote 6 of paragraph 67 of TD 2018/13 states

⁶ The Commissioner does not consider that the distribution has to be tax-free, or entirely tax-free, for the reasonable person test to be satisfied but being tax-free strongly supports the relevant conclusion being drawn.

39.  The fact that the payment or loan may be considered to be an ordinary commercial transaction does not, of itself, exclude the operation of section 109T, refer paragraph 69 of TD 2018/13.

40.  Where section 109T operates to treat a private company as having made a payment or loan to a shareholder, in determining the amount of that deemed payment or notional loan under section 109V or 109W, the Commissioner will take into account relevant factors occurring before the earlier of the due date for lodgment and the date of lodgment of the private company's return for the income year in which the company is taken to have made the deemed payment or notional loan.

41.  Where the interposed entity rules in Subdivision E of Division 7A apply, section 109X ignores the operation of 109K so that a deemed dividend is taken to arise under 109C as if the company has made a payment to the shareholder.

42.  Where Subdivision E of Division 7A deems a payment to be a dividend, section 109J cannot apply in respect of a notional loan that arises as the result of the application of the interposed entity provisions, refer paragraph 27 of Tax Determination TD 2012/12 Income tax: Division 7A: do the rules in Subdivision D of Division 7A of Part III of the Income Tax Assessment Act 1936 which exclude certain payments or loans from being treated as dividends under Subdivision B of Division 7A of that Act necessarily affect the circumstances in which a deemed payment or notional loan arises under Subdivision E of Division 7A of that Act? (TD 2012/2).

Section 109T - Application to this case

43.  As the loan facility is provided by X Pty Ltd, a private company in accordance with section 103A, to Z Pty Ltd, its shareholders' associated company, prima face section 109K would apply, so that no deemed dividends arise under section 109D in relation to these loans. However, as the loan facility funds borrowed by Z Pty Ltd (the interposed entity) would then be paid to Mr A (the target entity), a shareholder of X Pty Ltd and treated as repayments of the loans outstanding from Z Pty Ltd to the taxpayer, consideration of the interposed entity provisions in Subdivision E of Division 7A is necessary.

44.  As Mrs A is the spouse of Mr A, she is an associate of a shareholder of X Pty Ltd pursuant to section 318. As such, any payment from Z Pty Ltd to her could also be subject to Subdivision E of Division 7A.

45.  Given that the Z Pty Ltd is sufficiently influenced by Mr A as a 80% shareholder, subsection 318(1) is satisfied such that the interposed entities are considered associates of the target entities.

46.  As discussed above, where Subdivision E of Division 7A (sections 109T, 109V and 109X) applies so that X Pty Ltd is deemed to make the payment to the taxpayer, section 109J would not apply to the repayment to avoid the operation of section 109C.

47.  In this case, section 109T will likely apply given the funds lent to X Pty Ltd have been applied by Z Pty Ltd to repay loans to the taxpayers, resulting in a tax-free distribution from X Pty Ltd to the taxpayers. As discussed above and in TD 2018/13 paragraphs 66-67, this has led the Commissioner to conclude (having regard to all the circumstances) that X Pty Ltd made the respective loan facilities available to the shareholders' private companies, solely or mainly as part of an arrangement involving a payment from the shareholders' private companies to the shareholder.

48.  As discussed above for section 109T(1) to apply, per TD 2018/13 the intention of the arrangement is not relevant, nor is a purpose or intention to avoid Division 7A required per paragraph TD 2011/16. All that is required to satisfy paragraph 109T(1)(b) is for a reasonable person to conclude that the payment or loan from the private company to the interposed entity was part of an arrangement involving a payment or loan to the target entity (a back-to-back arrangement)

49.  Therefore, section 109T is likely to apply where the loan facility funds provided by X Pty Ltd have been used by Z Pty Ltd to repay loans outstanding to the taxpayer.

50.  In the event that section 109T has application, section 109V will need to be considered to determine the deemed payment amount.

Amount of private company's payment to the target entity through one or more interposed entities

51.  Subsection 109V(1) provides that if the target entity is paid an amount by the interposed entity, the Division operates as if the private company had paid the amount (if any) determined by the Commissioner to the target entity when the interposed entity paid the target entity.

52.  Subsection 109V(2) provides that in determining the amount of the payment the private company is taken to have made, the Commissioner must take account of:

(a)       the amount the interposed entity paid the target entity; and

(b)       how much (if any) of that amount the Commissioner believes represented consideration payable to the target entity by the private company or any of the interposed entities for anything (assuming that the consideration payable equals that for similar transactions at arm's length).

53.  Taxation Determination TD 2011/16 Income tax: Division 7A - payments and loans through interposed entities - factors the Commissioner will take into account in determining the amount of any deemed payment or notional loan arising under section 109T of the Income Tax Assessment Act 1936 outlines the factors the Commissioner will consider at paragraph 2.

These factors are as follows:

(a)       the amount that an interposed entity referred to in subsection 109T(1) (an 'interposed entity') loaned or paid the target entity referred to in that subsection (target entity) under the arrangement described in that subsection (the arrangement);

(b)       how much (if any) of the amount loaned or paid to the target entity by an interposed entity under the arrangement the Commissioner believes represented arm's length consideration payable to the target entity by the private company or an interposed entity for anything (other than its right to receive repayment of the loan and any relevant interest);

(c)       the extent to which any actual loans made as part of the arrangement have been repaid by that time;

(d)       the extent to which any actual payments made as part of the arrangement were converted into loans pursuant to subsection 109D(4A) that have been repaid by that time;

(e)       the extent to which any loan made from the private company to an interposed entity as part of the arrangement meets the criteria set out in section 109N (that is, 'a section 109N compliant loan') at that time;

(f)        the extent to which any payment made from the private company to an interposed entity as part of the arrangement was converted, pursuant to subsection 109D(4A) into a section 109N compliant loan by that time;

(g)       the extent to which any actual loans made as part of the arrangement would be covered by section 109M (loans in the ordinary course of the private company's business made on its usual terms applicable to arm's length parties); and

(h)       the extent to which the above factors reflect genuine transactions that are not designed to avoid the application of Subdivision E otherwise than as envisaged within the scheme of Division 7A (such as making a section 109N compliant loan to an entity that has an intention and capacity to repay a loan [in respect of which to the extent expected at the time when the Commissioner is determining the amount of deemed payment or notional loan, appropriate minimum yearly repayments have been made] or genuinely and in substance repaying loans in a manner that would not attract section 109R if it applied).

54.  In addition to the relevant factors above, the Commissioner may, in appropriate cases, consider (having regard to the intended purpose of Division 7A) the extent to which tax is otherwise payable because of the structure used in the arrangement, see paragraph 81 of TD 2018/13.

Section 109V - Application to the case

55.  In determining the amount of the payment X Pty Ltd may be taken to have made to the taxpayers under section 109V, the Commissioner will take into account the factors listed in paragraph 2 of TD 2011/16. Relevant to the taxpayers' circumstances is paragraph 2(c) of TD 2011/16, which states that the Commissioner will take into account to which any actual loans made as part of the arrangement have been repaid by that time.

56.  You explain that the payment of $x million from Z Pty Ltd to the taxpayers is a repayment of loans made by the taxpayers (as lenders) to the company (as borrower).

57.  Consequently, where 100% of payment made by Z Pty Ltd to the taxpayers represents a loan repayment, the amount determined under section 109V will be nil and no amount will be considered under Division 7A to be a deemed dividend under section 109C.

[1] All future legislative references are to the ITAA 1936, unless otherwise indicated.