Edited version of private advice

Authorisation Number: 1052171363625

Date of advice: 20 September 2023

Ruling

Subject: Commissioner's discretion under subsection 109Y(2)

Question

Will the Commissioner exercise his discretion, under subsection 109Y(2) of the Income Tax Assessment Act 1936 (ITAA 1936) to substitute the market value of the Company's net assets, in calculating its distributable surplus for the income year ended 30 June 20XX?

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

1.            The Company is an Australian proprietary company.

2.            The Company is the head entity of a global economic group of which the majority of entities are Australian based companies. It is the head of a tax consolidated group.

3.            The Company has historically made accounting losses on both a standalone and group basis.

4.            It is expected that the Company will continue to generate losses for accounting and taxation purposes for the short term. There are no profits in an accounting or commercial sense.

5.            Based on the Company's management accounts for the year ending 31 December 20XX its distributable surplus was less than zero.

6.            It was not anticipated that the distributable surplus position would be materially different as at 30 June 20XX. The Company does not forecast to have a distributable surplus at this date as further accounting losses are expected.

7.            The Company has developed and plans to implement a loan-funded share plan (Proposed Share Plan). The Proposed Share Plan is designed to achieve the objective of incentivising and retaining senior employees by way of provision of long-term proprietary interests in the Company.

8.            Under the Proposed Share Plan, Participants are offered loans for the sole purpose of funding the acquisition of shares for consideration that is no less than the market value as at the date of acquisition.

9.            The shares that will be offered under the Proposed Share Plan will be ordinary shares in the Company.

10.          No other loans to shareholders exist outside of the Share Plan or Proposed Share Plan.

11.          The Company's standalone accounting records are prepared in accordance with Australian Accounting Standards.

12.          A market valuation of the Company has been undertaken for the sole purpose of assigning value to shares to be issued under the Proposed Share Plan. Management considers the market value of the Company to be different to its net assets (as represented in its accounting records) as a result of internally generated goodwill at the company level as well as the subsidiary level. In accordance with AASB 138, internally generated goodwill is not permitted to be recognised by an entity.

13.          In accordance with AASB 127, the Company's investment in subsidiaries is recorded in its accounting records at cost rather than at market value. The Company does not revalue its share in subsidiaries in accordance with standard commercial practice and is not required to do so under the Australian Accounting Standards.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Subdivision D

Income Tax Assessment Act 1936 Subsection 109D

Income Tax Assessment Act 1936 Subsection 109D(1)

Income Tax Assessment Act 1936 Section 109NB

Income Tax Assessment Act 1936 Subsection 109Y(2)

Income Tax Assessment Act 1997 Section 83A-B

Income Tax Assessment Act 1997 Section 83A-C

Reasons for decision

All legislative references are to the ITAA 1936 unless otherwise stated.

Question

Will the Commissioner exercise his discretion, under subsection 109Y(2) to substitute the market value of the Company's net assets, in calculating its distributable surplus for the income year ended 30 June 20XX?

Summary

It is considered that the market value of the Company that is not reflected in its accounting records is not accessible such that the Company could pay dividends. Consequently, the Commissioner will not exercise his discretion under subsection 109Y(2) to substitute the value of the Company's assets in calculating its distributable surplus.

Detailed reasoning

Loans treated as dividends

1.             Division 7A treats certain amounts as dividends paid by a private company. In circumstances where a loan is made to an entity by a private company, subsection 109D(1) provides that the private company is taken to have paid a dividend at the end of the year of income if:

•        the private company makes a loan to the entity during the current year,

•        the loan is not fully repaid by the end of the current year,

•        either the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made, or a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time, and

•        Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year.

2.             The Company is planning to implement a Proposed Share Plan designed to incentivise senior employees by way of provision of long-term proprietary interests in the company. As a consequence of this arrangement, the first 3 dot points above may be satisfied.

3.             Section 109NB within Subdivision D provides that a loan that a private company makes to a shareholder or an associate of the shareholder is not taken to be the payment of a dividend for the purposes of section 109D if the loan was made solely for the purpose of enabling the shareholder or an associate of the shareholder to acquire an ESS interest under an employee share scheme (within the meaning of the Income Tax Assessment Act 1997 (ITAA 1997)) to which certain provisions within Subdivisions 83A-B and 83A-C of the ITAA 1997 apply.

4.             Subdivisions 83A-B and 83A-C of the ITAA 1997 only apply to an ESS interest if that ESS interest is acquired under an employee share scheme at a discount.[1] The shares under the Proposed Share Plan are intended to be allocated for no less than market value and not at a discount. Consequently, section 109NB will not apply to the loans intended to be issued under the Proposed Share Plan. There is no other provision within Subdivision D that would prevent the Company from being taken to pay a dividend because of the loan at the end of the current year.

5.             Since each of the requirements under subsection 109D(1) may be satisfied, the Company may be taken to pay a dividend at the end of the year of income.

Distributable surplus

6.             Section 109Y allows for a reduction of the amount of a dividend that a private company is deemed by Division 7A to pay in an income year to the extent it exceeds the distributable surplus for that year.

7.             A private company's distributable surplus for its income year is the amount worked out using the formula:

8.             If the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate.[3]

9.             In the Company's case its distributable surplus is calculated to be less than zero. The Company has valued its investments in subsidiaries at historical cost in its accounting records pursuant to AASB 127. Further, the majority of the market value of the Company pertains to internally generated goodwill, which is not required to be recognised under AASB 138.

10.          Taxation Determination TD 2009/5 Income tax: Division 7A: in exercising the discretion under subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936 to substitute an appropriate value for a private company's assets, can the Commissioner take into account the value of the company's assets not shown in the company's accounting records? (TD 2009/5) sets out what the Commissioner will take into account when deciding whether it is appropriate to exercise the discretion set out in subsection 109Y(2). Paragraph 4 states:

Where the company's accounting records understate the value of the company's assets because they are required to do so (for example where accounting standards require the value of internally generated goodwill to be omitted), the understatement is not itself an attempt to circumvent the operation of Division 7A. Subject to the qualification which follows, the Commissioner will not exercise his power under subsection 109Y(2) whenever accounting standards require the total value of assets to be understated; to do so would defeat the compliance simplification objective of the provision. However, where it is plain that the company, its shareholders and directors have acted, in making loans or other payments, in a way that treats the real and higher value of assets as their true value, that is, regardless of their value shown in the accounting records, and that the mischief against which Division 7A is directed is present, the Commissioner may, and generally will, substitute their true value.

11.          Relevantly to the Company's omission of goodwill in its accounting records, paragraphs 27 and 28 in TD 2009/5 states:

27. It is possible for a taxpayer to value its assets properly in accordance with accounting standards, but for the accounting standards to result in the undervaluation of the assets. The clearest example is 'goodwill', which if internally generated is generally not permitted to be valued by the standards. Goodwill is an asset in the legal and ordinary meaning of the word, and to omit the value of goodwill from a calculation of the surplus value of a company's assets will result in its understatement. The considerations which cause accounting standards to preclude valuation of goodwill are not directly, or even at all, relevant to the taxation of informal company distributions. Just as it is not to the point to show that 'profits' for company law purposes may diverge from the 'distributable surplus' for tax purposes, so it is not in itself conclusive against the exercise of the power to revalue assets to show that the company's accounting records are correctly prepared in accordance with the accounting standards.

28. However, as a matter of practice, the Commissioner would not adjust the book value of assets shown in properly prepared accounts merely because the value of internally generated goodwill is omitted, and, more generally, would respect book values shown in proper accounts in the absence of matters pointing to an attempt to circumvent the Division. When, however, it is plain that the company, its shareholders and directors have acted in a way that treats the real and higher value of assets as the true value, regardless of the books, and that the mischief against which Division 7A is directed is present, the Commissioner will substitute those values. In other words, the discretion is there to protect the integrity of the Act, and it will be exercised when it is necessary to do so for that purpose. should be applied against significant undervaluations

12.          The undervaluation of asset in the Company's accounting records occurred as a result of omitting internally generated goodwill, in accordance with Australian accounting standards and as described at paragraph 27 of TD 2009/5. As paragraph 28 then explains, the Commissioner would not seek to adjust the book value of assets without evidence that there has been a deliberate attempt to circumvent Division 7A.

13.          Paragraph 9.2 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No.3) 1998 that enacted Division 7A states:

The purpose of the amendments is to ensure that private companies will no longer be able to make tax free distributions of profits to shareholders (and their associates) in the form of payments or loans.

14.          Based on the facts provided, the Proposed Share Plan does not appear to be an informal distribution of profits to shareholders. The Proposed Share Plan is a management incentive plan which is designed to incentivise and retain senior employees. Loans issued can only be utilised for the purpose of subscribing for shares in the Company.

15.          Further, the Company is in an accounting loss position and has not earned a profit. It had accumulated losses as at 31 December 20XX. It is considered that the market value of the Company that is not reflected in its accounting records is not accessible such that the Company could pay dividends.

16.          The objectives informing the implementation of the Proposed Share Plan, and the manner in which it will be implemented, indicate that its purpose is not to facilitate the informal distribution of profits in a manner intended to circumvent the operation of Division 7A.

Conclusion

17.          The loans are not a disguised distribution of profit to shareholders. The Commissioner will not exercise his discretion under section 109Y(2) to substitute the value of the Company's net assets for the purpose of calculating its distributable surplus under section 109Y.

[1] Section 725-150(1) of the ITAA 1997.

[2] Subsection 109Y(2).

[3] Subsection 109Y(2).