Written by Georgia Adams, Commercial Lawyer and Tax Specialist
Harry is an influencer who desperately needs money but does not want to dip into his family inheritance. He has an idea to borrow funds from his private company of which he is also a shareholder. He remembers his accountant telling him to watch out for Division 7A, but not knowing the repayment terms to use to avoid triggering the application of this section, he has his wife Meghan borrow the funds on 1 July 2020 from the private company at a rate of 1% p.a. so that he can afford more personal security guards.
It is now 30 June 2021 and you receive a call from Harry, who has just searched the term ‘deemed dividend’ on Google and is worried about the tax implications of his wife’s outstanding debt to the private company of $1,010,000. He intended Meghan to start paying back the loan and interest when they no longer needed so many security guards.
Meghan will face a maximum tax of 47%[¹] on the amount of the loan [²] that is not fully repaid before the lodgment day or due date of lodgment for the company’s income tax return. This is caused by the application of s 109D of the Income Tax Assessment Act 1936 (Cth) (ITAA36) to such circumstances unless subdivision D of Div 7A applies.
Div 7A (which contains s 109D) otherwise applies to the above arrangement. In general terms, Div 7A applies to certain loans, payments and debt forgiveness to private company shareholders or their associates such as spouses on or after 4 December 1997.
It also applies in circumstances where a private company has been entitled to an amount from the net income of a trust where the trustee has not paid the amount to the private company, and instead the trustee makes a payment to, loan to, or forgives a debt of a shareholder or of an associate of the shareholder of the private company.
The loan is not treated as a dividend in the year it is made if repayment on the terms set out in s 109N is effected in that year. But if that does not happen, the loan will be treated as a dividend under s 109E ITAA36 at the lodgement day or due date of lodgement for the company’s income tax return, with any shortfall in minimum yearly repayments (assuming the repayment shortfall is less than the amount of the company’s distributable surplus as at 30 June of the income year) being assessable under s 44 ITAA36 at the end of the income year following the year the loan was made. The consequence of this is that loan repayments are not required in the year in which the loan is made, but must be made in each subsequent year in order to avoid the repayments becoming deemed dividends.
If the company’s loan agreement satisfies the definition of a genuine loan pursuant to s 109N ITAA36, then Harry and Meghan will have nothing to worry about.
Swings and Misses
You request a copy of the loan agreement and receive merely an exchange of letters and emails containing agreed terms that looks like a copy-paste job from material on a Californian law firm website. Despite this, the ATO has indicated in TD 2008/8 that even this dog’s breakfast can sufficiently constitute a written confirmation of the existence of a loan agreement for the purposes of s 109N(1)(a).
You immediately notice that the rate of interest payable at 1% p.a. will not be equal to or exceed the benchmark rate for the years after the year in which the loan was made as required by s 109N(1)(b) ITAA36. You explain to Harry that the benchmark rate is sourced from the Reserve Bank’s last published indicator lending rates such as the current owner-occupier variable housing rate set by the RBA. This was 4.52%[³] p.a. for the year of income ended 30 June 2021, which is more than four times higher than the rate of interest stipulated in the loan agreement.
Lastly, the agreement does not specify the required maximum term of seven years, or 25 years where secured by a mortgage over real property with the value of the property at least 110% of the amount of the loan (s 109N(3) ITAA36).
Consequently, the entire loan appears to be a deemed dividend under Div 7A ITAA36.
As such it is not frankable (s 202-45(g)(i) ITAA97) unless Harry and Meghan can prove on the balance of probabilities that the application of Div 7A is a consequence of an honest mistake or inadvertent omission (TR 2010/8). For example, Harry and Meghan could claim that they had no idea of the existence of Div 7A nor its potential application to their circumstances.
However, this claim would surely fail if there was either deliberate effort to remain ignorant of the operation of Div 7A up to the time when it was triggered (wilful blindness) or if they were made aware of the relevant provisions before that time. If they are successful in establishing honest mistake or inadvertent omission, then the Commissioner could disregard the deemed dividend or at least permit it to be frankable (in the case of a shareholder) under s 109RB ITAA36.
Remedies ex Debt Forgiveness
You raise these red flags with Harry and Meghan and tell them that you can either consolidate the terms of their loan agreement into a single contract with an effective date of the loan as at 1 July 2020 or draft a deed of variation to the loan agreement so that the loan complies with s 109N ITAA36 before the earlier of the private company lodging its income tax return or the due date of lodgement. Alternatively, you could advise that Meghan should immediately repay the loan before the year end, or that Harry’s company should declare a franked dividend. In a situation where the date of compliance with s 109N had passed, you could make a written application to the Commissioner to exercise his discretion under s 109RB ITAA36.
In response to this, Harry and Meghan ask whether Harry is simply able to sell his shares in the private company (this would give rise to CGT implications) and then have the company forgive the debt to his wife, so that Meghan would no longer be captured by the definition of an associate to a shareholder of his company and the transaction would no longer be subject to the operation of Div 7A.
Unfortunately, this is unlikely to be a viable option because a reasonable person would conclude that the amount is only forgiven because Meghan was an associate of a shareholder at some time. This means that s 109F ITAA36 would still deem the amount forgiven to be a dividend.
You also explain that their proposed sequence of events may be interpreted by the ATO as a contrived plan to avoid tax and the Commissioner may in such circumstances form the view that Part IVA ITAA36 is triggered.
For more than a brief snapshot of Div 7A deemed dividends and for more information on whether a loan, payment, debt forgiveness, credit, property transfer or other benefit from a private company to a shareholder or shareholder’s associate constitutes a deemed dividend under Division 7A ITAA36, please contact commercial lawyer and tax specialist, Georgia Adams, at Owen Hodge Lawyers.