Taxpayers may apply to seek the Commissioner's discretion to disregard the operation of Division 7A or to allow a deemed dividend to be franked.
Once a Division 7A breach has been identified, the decision making process to determine if the discretion can be exercised may commence.
The decision whether or not to exercise the Commissioner’s discretion is a two step process:
STEP 1
Determine whether the relevant breach of Division 7A resulted from an honest mistake or inadvertent omission.
Only if you are satisfied that the answer at step 1 is YES can you proceed to step 2.
STEP 2
Determine whether the Commissioner should exercise his discretion to disregard a deemed dividend, or allow that dividend to be franked.
Generally a decision by the Commissioner to disregard a deemed dividend will be made on the condition that specified corrective action is undertaken within a specified time.
In this fact sheet, a reference to a shareholder or their associate is also a reference to:
- an entity that has been a shareholder, or
- an entity that has been an associate of a shareholder.
How can an exercise of the Commissioner's discretion be requested?
Generally, you must apply to the Commissioner to exercise his discretion to disregard the deemed dividend or to allow the private company to choose to frank the dividend. The application would normally be in writing and include all the information necessary for the Commissioner to make a decision. There is no prescribed or standard application form.
Any request for an exercise of the Commissioner's discretion should include sufficient information to demonstrate to the Commissioner that the failure to comply with one or more of the provisions of Division 7A was the result of an honest mistake or inadvertent omission.
What factors does the Commissioner consider for exercising the discretion?
You will need to demonstrate to the Commissioner that the failure to meet the requirements of Division 7A was the result of an honest mistake or an inadvertent omission.
Once it has been established that there was an honest mistake or inadvertent omission, the Commissioner is able to decide whether or not to exercise the discretion. The Commissioner must have regard to factors specified in the legislation. The respective weighting of each factor depends on the particular circumstances of each entity requesting the exercise of the discretion.
The factors specified in the legislation are:
- the circumstances that led to the mistake or omission that caused the deemed dividend to arise
- the extent to which action had been taken and how quickly action had been taken to correct the mistake or omission
- whether Division 7A had previously operated in respect of the relevant entities and in what circumstances this had occurred, and
- any other matter that the Commissioner considers relevant.
In your request for the exercise of the discretion, you should address each of the first three factors to the extent that they are relevant to you individual circumstances. You should also include any other matters that you consider relevant, such as the amount of the dividends involved. The Commissioner may also request information that he considers relevant to the exercise of the discretion in your circumstances.
Corrective action
Certain amounts paid, lent or forgiven by a private company to shareholders or their associates may be treated as being a deemed dividend for tax purposes under Division 7A of the Income Tax Assessment Act 1936 subject to some exclusions. However, to encourage compliance we have discretion to disregard this outcome if the deemed dividend arises as a result of an honest mistake or inadvertent omission.
When deciding whether or not to exercise discretion, one of the factors we consider is the extent to which corrective action has been taken and, if so, how quickly that action was taken. Alternatively, if corrective action has not been fully undertaken prior to the ATO's discretion being sought, we may exercise our discretion subject to the condition that corrective action is taken within a specified time period.
Corrective action is significant as the law requires the Commissioner to consider:
- the extent to which the private company, shareholder or associate or any other entity whose conduct contributed to the failure to comply has taken action to try to correct the mistake or omission, and
- if so, how quickly the action was taken.
There are other factors that the Commissioner must consider. The respective weighting of each factor depends upon the actual circumstances of each case.
What is corrective action?
Appropriate corrective action should put the relevant parties in the position that they would have been in if Division 7A had not been breached.
Corrective action includes:
- converting the payment, loan or debt forgiveness to a loan that complies with section 109N of the Income Tax Assessment Act 1936 (‘section 109N’)
- making catch-up or shortfall minimum yearly repayments as if the transaction always complied with section 109N (plus interest compounded to reflect non-payment in earlier years).
See also:
Example
In the 2013 income year, ABC Pty Ltd loaned $700,000 to an associated trust, the XYZ Trust.
The Commissioner exercised his discretion subject to the following corrective action being taken in the 2016 income year:
- A loan agreement must be entered into commencing in the year in which corrective action is taken and conclude in the year in which it would have concluded had it been entered into at the time the original loan was made. In this case, that would be 2020.
- Under the loan agreement, the interest rate applicable must equal or exceed the benchmark interest rate for the year (these rates are published by the Reserve Bank of Australia).
- XYZ Trust must make catch up repayments of principal and interest in respect of the 2014, 2015, 2016 and 2017 income years.
Calculations
The formula for calculating the minimum yearly repayments that XYZ Trust must make is as follows:
Table 1 below illustrates the minimum yearly repayments that would have been payable had a complying loan agreement been entered into at the time the original loan was made.
|
Year |
Interest Rate |
Opening Balance |
Interest Amount |
MYR |
Ending Balance |
|---|---|---|---|---|---|
|
|
% |
$ |
$ |
$ |
$ |
|
2014 |
6.20 |
700,000 |
43,400 |
126,287 |
617,113 |
|
2015 |
5.95 |
617,113 |
36,718 |
125,300 |
528,531 |
|
2016 |
5.45 |
528,531 |
28,804 |
123,600 |
433,735 |
|
2017 |
5.40 |
433,735 |
23,422 |
123,457 |
333,700 |
|
TOTAL INTEREST |
132,344 |
|
|||
Table 2 illustrates the amount of catch-up payment that XYZ Trust must make as part of their corrective action (assuming no repayments have been made in any prior year).
|
Year |
Interest Rate |
Opening Balance |
Interest Amount |
MYR |
Ending Balance |
|
|---|---|---|---|---|---|---|
|
|
% |
$ |
$ |
$ |
$ |
|
|
2014 |
6.20 |
700,000 |
43,400 |
- |
743,400 |
|
|
2015 |
5.95 |
743,400 |
44,232 |
- |
787,632 |
|
|
2016 |
5.45 |
787,632 |
42,926 |
- |
830,558 |
|
|
2017 |
5.40 |
830,558 |
44,850 |
- |
875,408 |
|
|
Catch up Payment Due by 30 June 2017 |
541,708 |
333,700 |
||||
|
TOTAL INTEREST |
175,408 |
|
||||
In both Table 1 and Table 2, the “interest amount” payable in each year is calculated using the benchmark interest rate for each of the relevant years. However, because no repayments have been made in any year, the total “interest amount” payable is compounded in Table 2.
After the catch up payment of $541,708 is made in the 2017 year (which includes the 2017 minimum yearly repayment), the outstanding balance is what it would have been had a complying loan agreement been put in place at the commencement of the loan. The interest component of the catch up payment would be included in the assessable income of ABC Pty Ltd in the 2017 year.
See also:
Consequences of the Commissioner using his discretion
Disregard a deemed dividend
The Commissioner may decide to disregard the deemed dividend that otherwise arises under Division 7A.
The Commissioner may make his decision subject to a condition that:
- the shareholder, associate of the shareholder, or any other entity must make specified payments to the private company or another entity within a specified time – for example, an amount equal to the minimum yearly repayments that would have been made if all the conditions of Division 7A had been complied with, and/or
- a specified requirement of Division 7A be met within a specified time – for example, that the full amount of any payments made to a shareholder be converted into a loan that satisfies all the requirement set out in section 109N for the income year in which the loan was made.
If these conditions are not complied with by the specified timeframe, the deemed dividend is not disregarded.
See also:
Allow dividend to be franked
The Commissioner may alternatively decide that the private company may choose to frank the deemed dividend. If the private company does frank the deemed dividend, the private company's franking account will be debited.
The Commissioner's discretion to allow dividends to be franked would only apply where the dividend has been deemed to have been paid to a shareholder and not to an associate of a shareholder.
An amount included as if it was a dividend in the assessable income of an entity under Subdivision EA of Division 7A, is not frankable.
How will I be informed of the exercise of the Commissioner's discretion?
If the discretion is exercised, you will receive written advice that the amount that would otherwise be treated as a deemed dividend is disregarded, or the company will be given permission to frank the dividend.
Where the company is given permission to frank the dividend, , the dividend will be assessable income to the shareholder or associate of the shareholder, with the availability of a franking credit.
What if the discretion is not granted?
If the discretion is not exercised you will be advised in writing and the deemed dividend must be included as an unfranked dividend in your income tax return.
If you are dissatisfied with the Commissioner's decision you may lodge an objection to your assessment for the income year in which the deemed dividend arises and the decision will be reviewed. If your objection is unsuccessful, you may appeal the objection decision to the Administrative Review Tribunal.
Examples
While they are not prescriptive, the examples below demonstrate if there may be an honest mistake or inadvertent omission:
Example 1
A private company makes a loan to a shareholder in the 2013-14 income year for $100,000. In making the loan, a written agreement is prepared and the term of the loan is seven years.
However, after the return for the 2014-15 income tax year has been lodged the shareholder discovers that the company had made a mistake and advised the shareholder of the wrong interest rate when calculating the minimum yearly repayment. The shareholder only made minimum repayments of $19,000 in 2014-15 instead of the required $20,000. A deemed dividend has arisen as the repayments were lower than required. Once the shareholder realised the payments were lower than required, he corrected that mistake by paying an additional $1,000 in the 2015-16 income year. This additional payment meant that the shareholder had now paid an amount equal to the amount that would have been paid if the correct interest rate had been used in the previous income years. The shareholder also immediately advised the Commissioner that lower repayments had been made and requested that the Commissioner exercise the discretion.
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
It is necessary to show that the lower minimum repayments were the result of an honest mistake regarding the correct amount of those minimum yearly repayments. The attempt by the company to comply with the requirement of Division 7A by having a written agreement and making yearly repayments in respect of the loan are relevant in this context.
Step 2: Factors the Commissioner should consider when deciding to exercise his discretion:
- that there was a loan agreement in place between the company and the shareholder that satisfied all of the requirement of section 109N
- the use of the wrong interest rate to calculate the minimum yearly repayment resulted in a relatively small under payment
- once the shareholder discovered the mistake, the taxpayer took action to promptly advise the Commissioner of the mistake
- the shareholder took steps to correct the mistake and to discharge their legal obligation under the loan agreement to make a minimum yearly repayment of $20,000.
Decision
- It would be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- It is not necessary to impose conditions because appropriate corrective action has already been taken by the taxpayer.
Example 2
In the 20015--16 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a shareholder in the 2012-13 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the relevant income years. The shareholder thought that loan documentation was not necessary provided the interest charged was commercial in nature.
Since there was no written loan agreement in place before the private company's 2013 lodgment day, a dividend was deemed to have been paid to the relevant shareholder.
The shareholder or the private company (or both) may apply to the Commissioner to exercise his discretion to disregard a deemed dividend. Alternatively, the Commissioner may make a decision under this provision without being asked to do so by the company or shareholder.
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
In order for the Commissioner to exercise his discretion, it must be established that the failure to enter into a loan agreement that satisfies the requirement of section 109N was the result of an honest mistake or inadvertent omission. In this context, evidence of the shareholder attempting to comply with the intent of Division 7A (for example, by making yearly repayments in respect of the loan) would be relevant.
Step 2: Factors the Commissioner should consider when deciding to exercise his discretion:
- the nature of the two mistakes
- the level of interest actually charged by the company on the loan
- the actual making of yearly repayments on the loan for each year since the loan was entered into
- whether Division 7A has operated previously in respect of either the private company or the shareholder.
Decision
- It would be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- A complying loan agreement is executed and the shareholder to make additional payments equal to the difference between the actual repayments made and the repayments that would have been made including any compounding interest.
Example 3
A business consists of a private company (ABC Pty Ltd) and XYZ trust. Both entities are controlled by Sam and Mel. The trust's beneficiaries are Sam and Mel and they are also shareholders of the company. The trust owns land and buildings that are mortgaged to a financial institution. The company has a loan with a different financial institution. The interest on both loans is tax deductible as the loans are used for income generating purposes.
In the 2015-16 income tax year, the company and the trustee of the XYZ trust decide to consolidate their debts. The company extends its pre-existing loan facility and pays out the loan that the trust has with its bank. The discharge by ABC Pty Ltd of the debt owed by the XYZ trust to the financial institution is a payment under section 109C and, given that the trust estate is an associate of the shareholders of ABC Pty Ltd, Division 7A will deem a dividend to be paid by the private company to the trustee of the XYZ trust as a deemed shareholder in ABC Pty Ltd.
The trustee applied to the Commissioner to exercise his discretion to disregard the deemed dividend as soon as it became aware that Division 7A deemed a dividend to have been paid.
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
In order for the Commissioner to exercise his discretion, it must first be established that the officers and employees of the private company and the trustee made an honest mistake as to the operation of Division 7A to the debt consolidation.
Step 2: Factors the Commissioner should consider when deciding to exercise his discretion
- the circumstances surrounding the mistake or omission, including the amount of the deemed dividend
- the commercial nature of the transaction between the company and the trust
- that once the taxpayers discovered the problem they brought the matter to the Commissioner's attention.
Decision
- It would be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- As a condition of exercising the discretion, the Commissioner could require that the payment of the debt be treated as a loan by ABC Pty Ltd to the trust, that the loan be in writing and satisfy all of the requirements of section 109N, and that minimum yearly repayments be made for relevant income years that would have been required had the written loan agreement be put in place by the required time.
Example 4
Fred and Jen operated a number of separate businesses through different entities including a private company and a trust. They were the trustees of the trust and the only shareholders and directors of the private company. The beneficiaries of the trust are Fred and Jen and members of their immediate family.
During the 2013-14 income year, the trust was incurring substantial losses due to a downturn in business conditions. As no other source of funds was available, the private company made loans to the trust for working capital purposes during the year.
In preparing the 2013-14 income tax returns, their tax adviser considered the application of Division 7A but mistakenly believed that only loans to individual shareholders would be subject to Division 7A. There was no qualifying section 109N written loan agreement put in place before the lodgment day of the private company's 2013-14 tax return and no loan repayments had been made to the private company. However, the loan is recognised in the balance sheets of the private company and the trust and the loan is minuted along with a note that the trust is envisaged to resume profitability by the 2016-17 year, at which time loan repayments will commence.
Fred and Jen changed tax advisers during the 2015-16 income year and the new tax adviser brought to their attention the Division 7A problem in the 2013-14 year. On finding out about the problem, Fred and Jen wished to correct the mistake and promptly advised the Commissioner. Division 7A had not operated previously in relation to the private company or the trustee.
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
Step 2: Factors the Commissioner should consider when deciding to exercise his discretion
- the fact that the mistake was the result of a misreading of the legal requirements of Division 7A by a professional adviser
- the relatively short period of time that has elapsed between the year in which the dividend was deemed to be paid and the notification to the Commissioner
- the disclosure of the transaction as a loan in the balance sheets of the private company and trust
- the quantum of the sums involved
- that Division 7A had not operated previously in relation to the private company or the trustee.
Decision
- It would be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- As a condition of exercising his discretion, the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and for the trustee to make additional payments equal to the repayments that would have been made if the trustee had satisfied the requirements of section 109E.
Example 5
In the 2015-16 income year, the Commissioner undertakes an audit of EFG Pty Ltd. In the course of the audit, the Commissioner discovers that an interest free at call loan was made to a shareholder in the 2013-14 income year. There was no documentation supporting the loan and no repayments have been made. Nor was the loan disclosed in the company's books of account. In addition, the loan was made out of income that was not disclosed in the tax return of EFG Pty Ltd for the 2013-14 income year.
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
On the basis of the objective evidence, the taxpayer has failed to establish that the deemed dividend was the result of an honest mistake or inadvertent omission. Rather it appears that the company has deliberately ignored the operation of Division 7A and has simply sought to distribute undisclosed profits to a shareholder
Step 2: Factors the Commissioner should consider when deciding to exercise his discretion.
Not relevant because Step 1 was not satisfied.
Decision
- It would not be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- In such a situation the pre-requisite for the Commissioner to exercise his discretion has not been satisfied.
Example 6
Fred and his wife Wilma the directors and shareholders of Iron Age Pty Ltd, a private company carrying on metal fabrication work.
Fred and Wilma also operate a separate business that installs metal fencing through a partnership structure.
Fred and Wilma are both in their early 70’s.
For many years, Wilma’s brother Barney, a sole practitioner completed all accounting work for Fred and Wilma. However, Barney suffered a series of strokes, Fred and Wilma became concerned that, because of Barney’s failing health he may have made mistakes in the private company’s income tax returns.
Fred and Wilma then engaged Nick, a tax agent, to review the tax affairs of Iron Age Pty Ltd. They instructed Nick to review the last three tax returns to ensure that that they were correct as well as preparing their current tax returns.
Fred and Wilma’s concerns are confirmed by Nick, who identifies the loan that the company made to Fred and Wilma’s partnership. Fred explains that the loan was to provide working capital during the early stages of the partnership, and that Barney had suggested that the partnership borrow the funds from the company because it would assist the partnership to generate income.
Fred tells Nick that the loan has been repaid, but that no interest had been paid by the partnership. Nick advised Fred and Wilma that the loan had breached Division 7A, and a deemed dividend has arisen because the loan was not placed on Division 7A complying loan terms. Nick advises Fred and Wilma to apply for the Commissioner’s discretion under section 109RB to disregard the deemed dividend.
Fred and Wilma instruct Nick to amend the relevant prior year returns. They also ask Nick to request that the Commissioner exercise his discretion under section 109RB. At the time of applying for the discretion, Fred and Wilma have also made a ‘catch up’ payment of principal, and for interest forgone by the company according to the principles of corrective action. The interest was calculated based on the amount that would have accrued had a compliant section 109N loan agreement been in place.
Decision-making process
Step 1: Did the deemed dividend arise as a result of an honest mistake or inadvertent omission?
- Nick’s analysis of Barney’s working papers demonstrate a progressive decline in Barney’s professional capacity.
- The evidence suggests that the breach of Division 7A occurred as a result of an honest mistake or inadvertent omission, precipitated by Barney’s health problems, and therefore subsection 109RB(1) has been satisfied.
Step 2: Will the Commissioner exercise his discretion? (Apply the factors in subsection 109RB(3) to make a determination)
- Fred and Wilma have been proactive in seeking review of prior year returns because they were concerned about Barney’s ability to carry out his duties.
- Fred and Wilma instructed Nick to make a voluntary disclosure to the ATO as soon as they were made aware of the Division 7A breach.
- Iron Age Pty Ltd had previously made personal loans to Fred, and on that occasion Barney had drawn up section 109N complying loan agreements, in respect of which minimum yearly repayments had been made. There was therefore a demonstrated attempt to comply with Division 7A in the past.
- There have been no previous instances where Division 7A has been breached by any of the relevant parties.
Decision
- It would be reasonable to conclude that the Commissioner’s discretion should be exercised.
Conditions
- It is not necessary to impose conditions pursuant to subsection 109RB(4) because appropriate corrective action has already been taken by the taxpayer.
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