Edited version of private advice

Authorisation Number: 1052130983361

Date of advice: 26 June 2023

Ruling

Subject: Trust - dividend

Question 1

Is the Company taken to pay a dividend to the Family Trust under subsection 109F(1) of the Income Tax assessment Act 1936 (ITAA 1936) if the Company forgives a debt of $Z (the Loan) owed to the Company by the Family Trust?

Answer

Yes.

Question 2

Will the Commissioner exercise his discretion under subsection 109G(4) of the ITAA 1936 to treat any forgiveness to which section 109F applies as not giving rise to a dividend paid by the Company to the Family Trust?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company was incorporated in 19XX in Australia. Its directors and equal shareholders are individual A and individual B.

The corporate trustee ATF the Family Trust was settled by deed dated XX month in 20XX. The beneficiaries include individuals A, B and their children. Individual A is the appointor, and the sole director and secretary of the corporate trustee.

The Family Trust was established in order to purchase property which cost approximately $XX million, which was financed by a combination of a bank loan and a loan from the Company. Both loans have been paid down over the years but not extinguished.

In 20XX, the properties in the Family Trust were sold, resulting in a loss. After paying out the bank, a loan balance of $Z remained.

As at 30 June 20XX, the Family Trust owed the Company the sum of $Z. This loan is documented in an agreement which complies with the requirements of section 109N of the ITAA 1936 for unsecured loans.

The Family Trust has no assets apart from the initial settled sum. Its assets have been consumed by the fall in value of the properties it once owned.

The Company has a distributable surplus in excess of $Z.

Relevant legislative provisions

Section 109F of the Income Tax assessment Act 1936

Subsection 109F(1) of the Income Tax assessment Act 1936

Subsection 109F(2) of the Income Tax assessment Act 1936

Subsection 109F(3) of the Income Tax assessment Act 1936

Subsection 109G(4) of the Income Tax assessment Act 1936

Paragraph 109G(4)(a) of the Income Tax assessment Act 1936

Paragraph 109G(4)(b) of the Income Tax assessment Act 1936

Paragraph 109G(4)(c) of the Income Tax assessment Act 1936

Section 109N 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 109ZE of the Income Tax assessment Act 1936

Section 318 of the Income Tax assessment Act 1936

Paragraph 318(1)(d) of Income Tax assessment Act 1936

Section 245-35 of the Income Tax Assessment Act 1997

Section 245-37 of the Income Tax Assessment Act 1997

Subsection 995-1(1) of the Income Tax Assessment Act 1997

Section 960-100 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Summary

The Company is taken to pay a dividend under subsection109F(1) of the ITAA 1936 when it forgives the loan of $Z owed to it by the Family Trust.

Detailed reasoning

Subsection 109F(1) 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 all or part of a debt the entity owed the private company is forgiven in that year and either:

a) the amount is forgiven 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 amount is forgiven because the entity has been such a shareholder or associate at some time.

Subsection 109F(2) of the ITAA 1936 provides the amount of the dividend is equal to the amount of debt forgiven subject to the private company's distributable surplus as determined under section 109Y of the ITAA 1936.

Subsection 109F(3) of the ITAA 1936 provides that an amount of a debt is forgiven for the purposes of Division 7A of the ITAA 1936 if and when the amount would be forgiven under the commercial debt forgiveness rules in Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997).

Relevantly, section 245-35 of the ITAA 1997 provides a debt is forgiven if and when the debtor's obligation to pay the debt is released or waived or is otherwise extinguished other than by repaying the debt in full.

For a deemed dividend to arise under subsection 109F(1) of the ITAA 1936 in respect of a forgiven debt, the entity at the time the debt is forgiven must be:

• a shareholder in the private company, or an associate of such a shareholder and
• it owes the debt.

Meaning of the term 'entity'

Section 109ZD of the ITAA 1936 provides that the meaning of 'entity' is that pursuant to section 960-100 of the 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.

Meaning of the term 'associate'

Subsection 995-1(1) of the ITAA 1997 provides that the meaning of the term 'associate' is that provided by subsection 318 of the ITAA 1936. Specifically, paragraph 318(1)(d) of the ITAA 1936 relevantly provides that an associate of an individual includes:

a trustee of a trust where the primary entity, or another entity that is an associate of the primary entity because of another paragraph of this subsection, benefits under the trust;

In the current circumstances, the shareholders of the Company are individual A and individual B and both individual A and individual B are objects of the Family Trust. Therefore, the Family Trust is an associate of a shareholder of the Company under paragraph 318(1(d) of the ITAA 1997.

In accordance with subsection 109F(1) of the ITAA 1936 forgiven debts are treated as dividends. Subsection 109F(3) of the ITAA 1936 provides that:

An amount of a debt is forgiven for the purposes of this Division if and when the amount would be forgiven under section 245-35 or 245-37 of the ITAA1997, assuming the amount were a debt to which Subdivisions 245C to 245G of the ITAA1997 apply.

In this case section 245-37 of the ITAA1997 is not relevant. Section 245-35 of the ITAA1997 provides that:

A debt is forgiven if and when:

(a) the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full; or

(b) the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid.

Section 109Y of the ITAA 1936 limits the total amount of dividends taken to have been paid by a private company under this Division to the company's distributable surplus.

In this case, the Family Trust (being an associate of a shareholder in the Company) will be released from its liability to pay the loan it owes to the Company, and accordingly these debts will be forgiven. Therefore, the Company is taken to pay a dividend of $Z to the Family Trust at the end of the income year when the loan is forgiven.

Question 2

Summary

For subsection 109G(4) of the ITAA 1936 to apply, the Commissioner must be satisfied amongst other things that payment of the debt would cause the trustee undue hardship.

Detailed reasoning

Subsection 109G(4) of the ITAA 1936 provides that a private company will not be taken to pay a dividend under subsection 109F(1) of the ITAA 1936 if:

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

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

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

The phrase 'undue hardship' in paragraph 109G(4)(a) of the ITAA 1936 is not defined. 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, which also have drawn on the Macquarie Dictionary definitions of 'undue' as "unwarranted, excessive, too great or not proper, fitting or right; unjustified".

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

For a case where the debt of a trustee is forgiven, 'the entity' referred to in the paragraph is the entity that is described in subsection 960-100(2) of the ITAA 1997, being the legal person who is the trustee of a trust at any given time. This approach is supported by the nature of the test, which to operate requires that the entity has legal personality.

While trustees are personally liable for debts incurred in the performance of their role as trustees, they 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.

As trustees have recourse to trust assets before distribution to beneficiaries, trustees can frequently exercise their rights to indemnity and exoneration in discharging trust debts where trust assets exceed trust liabilities. In those instances, where trust assets exceed liabilities, a trustee will not suffer any financial detriment on the payment of a trust debt.

In cases where liabilities exceed trust assets and the trustee's liability is not limited, the trustee's assets may be exposed to repay trust debts without effective recourse through rights to indemnity and exoneration. Where the trustee's assets are so exposed, payment of a debt could, in those circumstances, result in a financial detriment that could be tested in terms of undue hardship.

In the circumstances here, the trustee's exposure in terms of the hypothesis posed by paragraph 109G(4)(a) of the ITAA 1936 is limited to its nominal paid up capital along with what might be recouped in terms of the trustee's rights to indemnity and exoneration (being the trust's nominal settled sum).

As the decided cases have shown, 'undue hardship', requires evidence of some exceptional consequence that would result from the enforcement of the debtor's obligation to pay so as to make that enforcement excessive, or too great, or not fitting or right, or unjustified. Mere difficulty or inability to pay other debts as they become due would not, of itself, amount to undue hardship.

Insolvency and liquidation of a trustee company with monetary exposure limited to nominal recoupment under its right of indemnity and exoneration along with a nominal issued capital is both the ordinary legal and economic consequence of a trustee company's inability to meet trust debts as they become due. As such these circumstances are unexceptional and in a monetary sense neither excessive nor too great.

For these reasons, the hypothesis posed in paragraph 109G(4)(a) of the ITAA 1936 cannot result in a conclusion of undue hardship. As paragraph 109G(4)(a) of the ITAA 1936 is not satisfied it is unnecessary to consider whether paragraphs 109G(4)(b) and 109G(4)(c) of the ITAA 1936 might be satisfied as regardless of that enquiry the Commissioner's power under subsection 109G(4) of the ITAA 1936 would not be open to be exercised.