House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 1 - Improving fairness and integrity in the tax system: distributions to entities connected with a private company

Outline of chapter

1.1 Schedule 1 to this Bill amends the non-commercial loan rules in Division 7A of the Income Tax Assessment Act 1936 ( ITAA 1936) to prevent a shareholder of a private company (or an associate of the shareholder) accessing tax-free dividends through the use of company assets, for less than their market value.

1.2 Other technical amendments are also made to strengthen the non-commercial loan rules to ensure that they operate in accordance with their original policy intent and cannot be circumvented by the use of a corporate limited partnership.

1.3 All of the legislative references in this chapter relate to the ITAA 1936 unless otherwise specified.

Context of amendments

1.4 The non-commercial loan rules in Division 7A are integrity provisions that treat payments, loans and other credits by private companies to shareholders (or their associates) as assessable dividends (unless they come within specified exclusions), to the extent that there are realised or unrealised profits in the company. Division 7A also ensures that an amount may be included in the assessable income of a shareholder (or their associate) if a private company has an unpaid present entitlement to income of a trust and the trustee makes a payment or loan to, or forgives a debt of, the shareholder of the private company (or their associate).

1.5 The definition of 'payment' for the purposes of Division 7A is contained in subsection 109C(3). A payment includes:

•

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

•

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

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to the entity; or

-

on behalf of the entity; or

-

for the benefit of the entity; and

•

a transfer of property to the entity.

1.6 For a payment to arise under a 'transfer of property', the ownership of an asset needs to pass from the private company to the shareholder (or their associate), or there must be a lease of real property in existence. As such, Division 7A does not cover the mere use of an asset, or licence or right to use an asset.

1.7 As part of the 2009-10 Budget, the Government announced that it would tighten the non-commercial loan rules to improve fairness and integrity in the tax law, by ensuring that benefits provided by a private company to a shareholder (or their associate), through the use of company assets, such as holiday houses, cars and other luxury items, at less than market value would be taxable. The Government also announced that it would make a number of other technical amendments to Division 7A to ensure that it operates in accordance with its original policy intent.

1.8 These amendments treat arrangements where a private company has provided an asset to a shareholder (or their associate) for their use (other than a transfer of property, which is already covered by paragraph 109C(3)(c) of the ITAA 1936) as a payment for the purposes of Division 7A. These changes ensure that Division 7A cannot be circumvented by the provision of an asset for use. The amendments in subsection 109CA(1) do not impact upon the operation of any of the existing payments in subsection 109C(3).

1.9 After consulting with small business and farming communities, the Assistant Treasurer announced changes to the measure via Press Release No. 051 of 14 September 2009. These changes included the introduction of an otherwise deductible rule and an exception for the use of certain residences, in addition to the exception for the minor use of certain company assets.

1.10 The Government has also included a provision that excepts the use of main residences that were purchased prior to 1 July 2009 as part of these amendments. This exception ensures that taxpayers who used a company structure to purchase a home, are not impacted by these amendments (subject to a company continuity of ownership test). These exceptions only apply to payments that arise because of the operation of section 109CA. That is, the exception applies to the use of certain dwellings, but not where there is a transfer of property within the meaning of paragraph 109C(3)(c).

1.11 In addition to the changes made to the definition of payment, these amendments also correct a number of other technical deficiencies that provide taxpayers with the opportunity to structure their affairs to circumvent the application of Division 7A.

Summary of new law

1.12 When a private company provides an asset to a shareholder, or an associate of the shareholder for use (other than a transfer of property which is covered by paragraph 109C(3)(c) of the ITAA 1936), a payment for the purposes of Division 7A will arise.

1.13 There are three exceptions to this treatment. They are for:

•

the minor use of company assets;

•

certain payments that would otherwise be allowable as a once-only deduction to the user of the asset; and

•

the use of certain residences.

1.14 Broadly, Subdivision EA of Division 7A operates where a private company has an unpaid present entitlement to income of a trust and the trust makes a payment, loan or forgiveness of debt to a shareholder of the private company or an associate of the shareholder in particular circumstances. These amendments to Subdivision EA ensure that the operation of the Subdivision cannot be circumvented by interposing an entity between either the trust making a payment or loan to a shareholder (or their associate) or between a trust and the private company that holds an unpaid present entitlement to an amount from the net income of the trust

1.15 Other technical amendments are also made to strengthen the non-commercial loan rules to ensure that they operate in accordance with their original policy intent and cannot be circumvented by the use of a corporate limited partnership, which is a partnership taxed like a company.

1.16 Amendments are also made to put beyond doubt that Division 7A applies to arrangements that involve a non-resident private company making a payment, loan or forgiveness of debt to a resident shareholder (or their associate).

Comparison of key features of new law and current law

Detailed explanation of new law

Payment that arises from the provision of an asset for use (other than a transfer of property)

1.17 The definition of 'payment' in section 109C does not currently extend to a number of arrangements used by private companies to provide assets, for use, to their shareholders (or an associate of a shareholder).

1.18 These amendments extend the meaning of 'payment' to include the provision of an asset (other than a transfer of property) for use by an entity. This extension ensures that arrangements aimed at circumventing the operation of Division 7A, through the provision of an asset under a licence or other right to use, are now within the scope of Division 7A . [Schedule 1, item 13, subsection 109CA(1)]

1.19 For the purposes of subsection 109CA(1), the payment occurs as the use occurs . [Schedule 1, item 13, paragraph 109CA(2)(a)]

1.20 A payment may also occur when the asset is available for use to the exclusion of the company. As such, it does not matter when the right to use the asset is granted . [Schedule 1, item 13, paragraph 109CA(2)(b)]

Example 1.1

On 7 October 2006, Ngo Pty Ltd leases a car for five years and then provides the car to a shareholder (Barry) to use for the duration of that period. Barry pays Ngo Pty Ltd $5,000 per year for the use of the car. After 1 July 2009, the provision of this car, for use, will be a payment under Division 7A. The payment will occur on 1 July 2009 when the car is first available for Barry's use in the 2009-10 income year. It does not matter that the agreement was entered into in 2006 because the provision of the car continues in the 2009-10 income year. Because Barry has the right to use the car for the whole of the 2009-10 income year the value of the payment for the 2009-10 income year is based on 12 months of use. It does not matter that the car is not driven ('used') by Barry every day during the income year.

1.21 An asset may be available for the shareholder's use without a formal agreement. In addition, an asset may be available for use even though there is no actual use.

Example 1.2

Brian is a shareholder of a private company that owns a luxury yacht. He does not have a formal agreement with the company in relation to the yacht, however, he takes the yacht out every second weekend. Brian keeps the yacht at the company's business premises, but takes the key home. Brian stores several personal items on the yacht.

Brian's fortnightly use of the yacht is a payment under Division 7A. The availability of the yacht for Brian's use is also subject to Division 7A because the yacht is not readily available for use by the company. The company would need to arrange with Brian to get the key and for the removal of Brian's personal items before using the yacht. That is, the asset is available for Brian's use to the exclusion of the company.

Example 1.3

Marina is a shareholder of a private company that owns a city apartment. The apartment is generally available for rent. However, Marina asks the company not to rent the apartment out for a week so that she and her family can use the apartment over a long weekend. Marina's use of the apartment is a payment for the purposes of section 109CA.

1.22 If there is merely a general entitlement to use the company's assets, an asset is not available for a shareholder's use to the exclusion of the company.

Example 1.4

Peter is a shareholder of a private company that owns five cars for company use. Shareholders and their associates have general permission to use the cars on weekends if they are not being used for company business. Peter regularly takes one of the cars home.

Peter's use of the car that he takes home will be subject to Division 7A. This will include driving the car (actual use) and the availability of the car for his use to the exclusion of the company, such as when it is parked at home, or at a restaurant that Peter is visiting.

Although Peter may have general permission to use all five of the cars, he does not use all of them for the purposes of Division 7A. The four cars that Peter leaves at the company premises are available for the company to loan to another shareholder, employee, customer, or other party. That is, these cars are not available to Peter to the exclusion of the company.

1.23 Where an asset is used by more than one entity simultaneously, it is necessary to consider whether the use of that asset should be attributed to a particular entity or apportioned.

Example 1.5

Clare and her husband Martin are shareholders of a private company that owns a holiday house. Clare, Martin and their infant son Phoenix have a one-month holiday at the house over summer. They do not pay for the use of the holiday home.

Although Phoenix is an associate of Clare and Martin, the provision of the use of the asset is attributable to Clare and Martin. This is the case particularly because Phoenix has no power to enter into a contract with the company and because of his dependence on Clare and Martin. The company is not providing the holiday house to Phoenix for his use, and his incidental use of the house is secondary to that of Clare and Martin.

The use of the holiday house (at market value rates) can therefore be attributed to Martin and Clare in equal shares on the basis that they use the holiday house equally.

Example 1.6

Hayden is a shareholder of a private company. Hayden leases a car from the private company for 12 months for a nominal amount of $10,000. Hayden uses the car to drive his children to school in the morning. Hayden's wife (who is also a shareholder) sometimes drives the car on weekends.

The use of the car is attributable to Hayden's relationship with the company. The use of the car by Hayden's spouse and his children is secondary to his right to use the asset and is not provided by the company for their use, but Hayden's.

Hayden is assessed on the market value of the use of the car for the full 12 months, less actual consideration paid.

Valuation of a payment that arises from the provision of an asset for use (other than a transfer of property)

1.24 The amount of a payment is the amount that would have been paid for the provision of the asset by parties dealing at arm's length less any consideration actually paid. The amount of the payment is nil if the consideration paid equals or exceeds the amount that would have been paid by parties dealing at arm's length . [Schedule 1, item 13, subsections 109CA(10) and (11)]

Example 1.7

Matt is a shareholder of a private company that owns a holiday home. In the 2009-10 income year, Matt uses the holiday home for one week for which he pays the company 50 per cent less than the market value rent for the property. The market value rent for the property is $1,000 a week. The company has therefore made a payment to Matt of an amount of $500, which will be assessable to Matt under Division 7A, subject to the company having a distributable surplus.

1.25 Exceptions to a payment that arises from the provision of an asset for use (other than a transfer of property)

1.26 The use of an asset will not be a payment under section 109CA if it is covered by one of the exceptions. The exceptions are for the minor use of certain company assets, certain payments that would otherwise be allowable as a once-only deduction and the use of certain residences. The exceptions only apply to the operation of section 109CA and do not apply more broadly to the operation of Division 7A. For example, a transfer of a property to shareholder involving a main residence would still be a payment under paragraph 109C(3)(c) of Division 7A, while the mere use of a main residence may not be a payment.

Minor benefits

1.27 Subsection 109CA(4) provides that an amount will not constitute a payment if the provision of the asset would, if done in respect of the employment of an employee, be a minor benefit under section 58P of the Fringe Benefits Tax Assessment Act 1986 ( FBTAA 1986).

1.28 Section 58P of the FBTAA 1986 sets out when a minor benefit provided in, or in respect of a year of tax, is an exempt benefit and hence not subject to fringe benefits tax. Paragraph 58P(1)(e) of the FBTAA 1986 provides that the notional taxable value of a minor benefit in relation to the current year of tax must be less than $300. In addition paragraph 58P(1)(f) of the FBTAA 1986 sets out a number of other matters such as the infrequency and irregularity of the benefit which may lead to a conclusion that it would be unreasonable to treat the minor benefit as a fringe benefit for the current year of tax.

1.29 This exception will reduce compliance costs for taxpayers as they will not have to treat minor payments to shareholders of a private company (or their associates) that arise under new subsection 109CA(1), as payments that may give rise to a deemed dividend . [Schedule 1, item 13, subsection 109CA(4)]

Example 1.8

John is a shareholder of a private company that hires out trailers for $250 per day. The company owns a number of trailers, one of which the company made available to John during the 2009-10 income year to move furniture and other household items.

John is not an employee of the company. However, because the value of his one-off use of the trailer in the income year is less than $300 and his use of the trailer would be treated as a minor benefit under section 58P of the FBTAA 1986 if he was an employee, the use of the trailer does not constitute a payment under Division 7A.

Otherwise deductible payments

1.30 Subsection 109CA(5) provides that if the shareholder of a private company (or their associate) had incurred and paid expenditure in respect of the provision of the asset and a once-only deduction would have been allowable to the shareholder (or their associate), subsection 109CA(1) does not apply.

1.31 In determining whether an amount is otherwise deductible, the appropriate test is whether the payment for the use of the asset would otherwise be deductible to the user of the asset, not whether the user would be able to deduct the amount had they purchased the asset themselves . [Schedule 1, item 13, subsection 109CA(5)]

Example 1.9

Shop Pty Ltd owns a shopping centre. Audrey is a shareholder of Shop Pty Ltd and at various times during the 2009-10 income year she is provided with part of the property to run a gift wrapping service. Under her arrangement with Shop Pty Ltd, Audrey is not required to make payments to Shop Pty Ltd for her use of that part of the property.

Had Audrey made payments for the use of that part of the property she would be able to deduct those payments, as they would have been part of the expenses she incurred in running her business. Therefore, while Audrey's use of the property is within the scope of subsection 109CA(1), it is disregarded, as Audrey would have otherwise been able to deduct any payments made for the use of the property.

The exception would not operate if it was established that Audrey had in fact a lease of real property (that is, a transfer of property to an entity within the meaning of paragraph 109C(3)(c)). The exception in subsection 109CA(5) only applies to the extended meaning of payment in subsection 109CA(1).

A dwelling owned by a private company

1.32 The amendments contain two separate exceptions for the provision of certain kinds of dwellings.

1.33 The first exception is contained in subsection 109CA(6) and provides an exception for the provision of a dwelling for use by a shareholder or their associate (the entity) where that provision would not meet the otherwise deductible rule (that is, because the use is for private purposes). In order to qualify for the exception certain conditions must be met. These are that:

•

the entity or their associate is carrying on a business;

•

the entity or their associate uses or is granted or has a lease, licence or other right to use land, water or a building for the purpose of carrying on the business; and

•

the provision of the dwelling to the entity is connected with that use or with that lease, licence or other right to use the land, water or building to carry on the business.

1.34 It is also necessary for there to be a connection between the provision of the dwelling and that use, lease, licence or other right to use land, water or building in carrying on a business, even if the business is being carried on by an entity other than the entity living in the dwelling . [Schedule 1, item 13, subsection 109CA(6)]

Example 1.10

Aaron and Liz Jones are shareholders in a private company called Farm Pty Ltd and beneficiaries of the Jones Family Trust. Farm Pty Ltd owns a property called Greenacre on which the Jones Family Trust runs a farming business.

For the 2009-10 income year Aaron and Liz live in a dwelling on Greenacre. Aaron and Liz do not make payments to Farm Pty Ltd for the use of this dwelling.

As this use is for private purposes, it does not come within the otherwise deductible exception in subsection 109CA(5).

However, as their use of the dwelling is in connection with the Jones Family Trust using Greenacre to carry on a business, the provision of the dwelling by Farm Pty Ltd is disregarded for the purposes of subsection 109CA(1).

Liz's brother Tom who is also a shareholder of Farm Pty Ltd does the accounts for the Jones Family Trust from his harbour side dwelling in Sydney. Farm Pty Ltd also owns this dwelling. Tom's use of the harbour side dwelling is not connected to the use of the land, water or building on Greenacre and therefore is not eligible for this exception.

Example 1.11

Rebecca is a shareholder of a private company called Health Pty Ltd. She is also a doctor who runs a surgery. Rebecca runs her surgery in a house owned by Health Pty Ltd under a licence agreement. The surgery takes up approximately 40 per cent of the area of the house. Health Pty Ltd has also granted Rebecca a right to use the remaining 60 per cent of the house to live in. She does not pay Health Pty Ltd under either arrangement.

Rebecca's licence to use the part of the house to run her surgery is not a payment for the purposes of subsection 109CA(1). This is because she would have been allowed a once-only deduction if she had made a payment for that use.

Rebecca's use of the remainder of the house is also exempt due to the operation of subsection 109CA(6) as she is carrying on a business, using a building that she has been granted a licence to use and there is a connection between her carrying on the business and her using the remainder of the house as her dwelling.

Example 1.12

Ernie is a shareholder of a private company called Electric Co Pty Ltd. Electric Co Pty Ltd owns the dwelling that Ernie lives in. Ernie stores his tools at the dwelling, but does not otherwise use the land or building in carrying on his business. Ernie's use of the dwelling is not exempt under subsection 109CA(6) because he does not use land, water or buildings in carrying on his business. However, the dwelling may be an exempt main residence under subsection 109CA(7).

1.35 The second residence exception is for the provision of a main residence and is contained in subsection 109CA(7). This exception relates to dwellings that are the main residence of the shareholder (or their associate) of a private company, where the dwelling has been acquired by the private company before 1 July 2009. The exception is subject to a continuity of ownership test so that the exception is not carried over if the ownership of the private company changes.

Example 1.13

Jessica is the sole shareholder of a private company called House Pty Ltd. The sole asset owned by House Pty Ltd is a dwelling that the private company acquired in 2005. Jessica currently uses this dwelling as her main residence. As long as there is no substantial change in ownership of House Pty Ltd the provision of the dwelling by House Pty Ltd, for Jessica's use, is disregarded for the purposes of subsection 109CA(1).

However, in 2012, Jessica sells her ownership interest in House Pty Ltd to Gaurav. The sale of her interest in House Pty Ltd represents a change in the ownership of the company under section 165-12 of the Income Tax Assessment Act 1997. Hence, if Gaurav seeks to use the dwelling owned by House Pty Ltd as his main residence, without paying market value rates, his use of the house will be treated as a payment for the purposes of subsection 109CA(1).

Gaurav will then be liable to pay tax if the payment for the use of the house is not converted to a loan and either repaid before the lodgment day of the private company, or a loan agreement complying with Division 7A requirements is made (and subject to the private company having a distributable surplus).

Closely held corporate limited partnerships

1.36 Division 7A does not currently apply to corporate limited partnerships due to the operation of section 94N, which states that a reference to a private company in relation to the year of income does not include a reference to a corporate limited partnership.

1.37 Under these amendments, corporate limited partnerships that satisfy the requirements outlined in section 109BB are subject to the operation of Division 7A. Section 109BB sets out that a corporate limited partnership will be considered to be closely held for the purposes of Division 7A where it has fewer than 50 members or an entity has, directly or indirectly, and for the entity's own benefit, an entitlement to a 75 per cent or greater share of the income or capital of the partnership . [Schedule 1, item 11, section 109BB]

Example 1.14

Kariba L.P is a limited partnership that has one general partner and three limited partners. Kariba L.P is a corporate limited partnership under section 94D. As Kariba L.P has less than 50 members, it is subject to the application of Division 7A from the 2009-10 income year.

Interposed entities

Payments and loans made by a trustee through interposed entities

1.38 Under Subdivision E of Division 7A, where an entity is interposed between a private company and a shareholder or their associate (target entity), a payment or loan from the private company is treated as being made directly to a target entity if certain conditions are met. There are currently no corresponding rules that apply for the purposes of Subdivision EA, where a company has an unpaid present entitlement to an amount from the net income of a trust and an entity is interposed between the trust and the shareholder or their associate (the target entity). [0]

1.39 The existing Subdivision EA treats a payment or loan from a trust to a shareholder (or associate) as a payment or loan from the private company, if the company has an unpaid present entitlement from the trust.

1.40 Under these amendments, where a corporate beneficiary has a present entitlement to an amount from the net income of a trust estate and the whole of that amount has not been paid, and an entity is interposed between that trust and a target entity (the shareholder of the private company or their associate), the trust is treated as having directly paid or loaned an amount to the target entity for the purposes of Division 7A. Subdivision EA then operates as if the trustee makes a payment or loan to the target entity . [Schedule 1, item 25, sections 109XF and 109XG]

1.41 Sections 109XF and 109XG set out three conditions that must be met before a trustee is taken to have made a payment or a loan to a target entity:

•

there must be a payment or loan from the trustee to an interposed entity;

•

in circumstances where a reasonable person would conclude that the payment or loan was made as part of an arrangement to make a payment (paragraph 109XF(1)(b)) or loan (paragraph 109XG(1)(b)); and

•

the interposed entity, or another interposed entity, makes a payment (paragraph 109XF(1)(c)) or loan (paragraph 109XG(1)(c)) to the target entity.

[Schedule 1, item 25, subsections 109XF(1) and 109XG(1)]

1.42 Paragraphs 109XF(1)(a) and (b) and 109XG(1)(a) and (b) make reference to both a payment and a loan to ensure that the provisions operate in situations where a payment or loan is made to an interposed entity and the interposed entity then makes a loan or a payment to the target entity. The characterisation of the amount (as a payment or loan) will depend on the nature of the transaction between the last interposed entity and the target entity.

Example 1.15

Berry Pty Ltd has an unpaid present entitlement from Raspberry Trust. Raspberry Trust makes a payment to Strawberry Trust, who then makes a loan to Jane, who is a shareholder of Berry Pty Ltd, as set out in the diagram. The notional transaction between Raspberry Trust and Jane is treated as a loan, because the transaction between Jane and Strawberry Trust is a loan.

1.43 These amendments operate whether a single entity (the first interposed entity) is, or multiple entities are, interposed between the trust making the payment or loan and the target entity . [Schedule 1, item 25, paragraphs 109XF(1)(c) and 109XG(1)(c)]

1.44 It does not matter whether the interposed entity makes the payment or loan to the target entity at the same time as the first interposed entity receives a payment or loan from the trustee. The trustee is considered to have made the payment or loan at the time the interposed entity makes the payment or loan to the target entity . [Schedule 1, item 25, subsections 109XF(2) and 109XG(2)]

1.45 Where the interposed entity makes a payment to the target entity the amount is treated as a payment for the purposes of subsection 109XA(1). This means that the payment must be a discharge, or partial discharge, of a present entitlement attributable to an unrealised gain as required by paragraph 109XA(1)(b) . [Schedule 1, item 25, subsection 109XF(3)]

Example 1.16

On 1 March 2010, Green Pty Ltd enters into an arrangement involving, Green Trust, Low Trust and Vicki, who is a shareholder of Green Pty Ltd.

As part of this arrangement, the Green Trust declares a present entitlement of $100,000 to Green Pty Ltd. The present entitlement remains unpaid. Green Trust then loans $100,000 to Low Trust who makes a $100,000 payment to Vicki. The $100,000 payment to Vicki is a discharge of a present entitlement attributable to an unrealised gain in Low Trust (as set out in the diagram).

The effect of section 109XF is that, for the purposes of paragraph 109XA(1)(a), Green Trust has made a payment to Vicki.

Since the payment from Low Trust to Vicki is the discharge of a present entitlement attributable to an unrealised gain, paragraph 109XA(1)(b) is also satisfied. Paragraph 109XA(1)(c) is also satisfied because Green Pty Ltd has an unpaid present entitlement from Green Trust. Accordingly, section 109XB will apply to bring the payment within the scope of Division 7A.

Amount and timing of the payment or loan through interposed entities

1.46 The Commissioner of Taxation (Commissioner) will determine the value of the payment or loan made through an interposed entity under this type of arrangement . [Schedule 1, item 25, subsection 109XH(1)]

1.47 In determining this amount, the Commissioner is required to take into account the amount that the interposed entity paid or lent to the target entity, and how much of that amount represented consideration payable to the target entity by the trustee or any of the interposed entities . [Schedule 1, item 25, subsection 109XH(2)]

1.48 Any repayments made by the target entity to the interposed entity will be taken into account in working out the value of the loan under Division 7A . [Schedule 1, item 25, subsection 109XG(3)]

1.49 The amount determined by the Commissioner cannot exceed the amount of the unpaid present entitlement that the private company has from the trust . [Schedule 1, item 25, subsection 109XH(3)]

1.50 The time of the loan or payment is when the loan or payment is made to the target entity by the interposed entity . [Schedule 1, item 25, subsection 109XH(4)]

Entitlements to trust income through interposed trusts

1.51 One of the requirements to satisfy subsections 109XA(1) and (3) is that a private company, is or becomes, presently entitled to an amount from the net income of a trust estate that makes the payment, loan or debt forgiveness to the shareholder (or their associate), and that amount has not been paid.

1.52 Interposing one or more trusts between the private company and the trust that makes the payment or loan to the shareholder (or their associate) circumvents the existing operation of Subdivision EA.

1.53 Under subsection 109XI(1), the private company will be treated as having a present entitlement to an amount from the net income of the target trust for the purposes of Division 7A, where:

•

one or more trusts is interposed between a private company and the target trust (the trust making the payment to the shareholder of the private company or their associate); and

•

a reasonable person would conclude that the private company is, or becomes, entitled to an amount from the net income of the interposed trust, solely or mainly as part of an arrangement involving an entitlement to an amount from the target trust.

[Schedule 1, item 25, subsection 109XI(1)]

1.54 It does not matter whether the private company became, or becomes, entitled to the amount from the net income of an interposed trust at the same time the interposed trust became, or becomes, presently entitled to an amount from the net income of the target trust . [Schedule 1, item 25, subsection 109XI(2)]

1.55 The private company is taken to be, or to become, presently entitled to an amount from the net income of the target trust at the time the private company is, or becomes, presently entitled to an amount from the interposed trust . [Schedule 1, item 25, subsection 109XI(7)]

1.56 The amount that the private company is taken to be, or to become, entitled to from the net income of the target trust is the amount determined by the Commissioner. It may be different to the amount to which the interposed trust became presently entitled . [Schedule 1, item 25, subsection 109XI(4)]

1.57 In determining this amount, the Commissioner must have regard to the amount the private company is entitled to from the net income of the first interposed trust and how much of that amount the Commissioner considers represents consideration payable to the private company . [Schedule 1, item 25, subsection 109XI(6)]

1.58 For the purposes of section 109XI the amount of the present entitlement that the private company is taken to be, or to become, entitled to from the net income of the target trust, is limited by the amount of the present entitlement that the interposed trust is, or becomes, presently entitled to from the net income of the target trust . [Schedule 1, item 25, subsection 109XI(5)]

1.59 A private company will not be treated as being presently entitled to an amount if that amount is included in the assessable income of a shareholder or their associate under another provision in Subdivision EA . [Schedule 1, item 25, subsection 109XI(3)]

Example 1.17

Michael is a shareholder of Bennetts Pty Ltd and Bennetts Pty Ltd is a beneficiary of Harvey Trust. In the 2009-10 income year, Michael receives a payment from the trustee of the Wilson Trust, which is attributable to an unrealised gain. He receives this payment because of his shareholding in Bennetts Pty Ltd. Michael also receives a $2,000 non-compliant Division 7A loan from the Harvey Trust.

Bennetts Pty Ltd is not presently entitled to an amount from the net income of the Wilson Trust. However, Bennetts Pty Ltd is entitled to $10,000 from the net income of the Harvey Trust (the first interposed trust) and Harvey Trust is presently entitled to $10,000 from the net income of the Wilson Trust. These amounts remain unpaid.

The loan made by the Harvey Trust to Michael will be included in Michael's assessable income under ordinary operation of subsection 109XA(2).

Bennetts Pty Ltd is taken to be presently entitled to $8,000 from the Wilson Trust, which is the unpaid present entitlement of $10,000 from the Harvey Trust, reduced by the $2,000 loan amount that is included in Michael's assessable income under another provision of Subdivision EA.

Loan-back agreements related to the distribution of an unrealised gain

1.60 Under the current law, payments under Subdivision EA must be attributable to an unrealised gain. The amount of the payment that can be taken to be paid is limited to the present entitlement owed to the company that remains unpaid.

1.61 Taxpayers have been entering into arrangements whereby the amount of the payment received by a shareholder (or their associate) from the trustee of a trust, is significantly more than the unpaid present entitlement held by the private company to circumvent the operation of Division 7A.

1.62 The shareholder (or their associate) then loans back to the trust the amount of the payment that exceeds the unpaid present entitlement, held by the private company.

1.63 In a subsequent income year, the trustee declares a present entitlement to the private company that remains unpaid. The trustee makes a loan repayment to the shareholder (or their associate). The repayment of the loan to the shareholder (or their associate) is not caught by the operation of Division 7A as the payment is no longer a discharge of, or a reduction in, a present entitlement of the shareholder (or their associate) that is wholly or partly attributable to an amount that is an unrealised gain within the scope of subsection 109XA(1).

1.64 These amendments ensure that the requirement for the amount to be a discharge of a present entitlement attributable to an unrealised gain is disregarded where the conditions contained in subsection 109XA(1A) are satisfied.

1.65 Subsection 109XA(1A) sets out that paragraph 109XA(1)(b) is disregarded when:

•

subsection 109XA(1) has previously applied because the trustee made a payment to the shareholder (or their associate) in an earlier income year;

•

the shareholder (or their associate) makes a loan or loans back to the trustee on or after 1 July 2009 and a reasonable person would conclude that the shareholder (or their associate) made or intended to make the loan or loans to the trustee at the time of, or before, the original transaction took place; and

•

the trustee makes a repayment of all or part of the loan.

[Schedule 1, item 18, subsection 109XA(1A)]

1.66 Section 109J (which provides that a private company is not taken to pay a dividend because of a payment, to the extent that the payment discharges an obligation of the private company to pay money to the entity on an arm's length basis) does not apply where subsection 109XA(1A) applies. This is to ensure that the loan agreement between the trust and the shareholder of the private company cannot be used to avoid the application of subsection 109XA(1A) . [Schedule 1, item 18, subsection 109XA(1B)]

Example 1.18

In the 2010-11 income year Trust A re-values an asset and makes a distribution of $5 million to Lucas who is a shareholder of Willis Pty Ltd. Willis Pty Ltd has a $500,000 unpaid present entitlement to an amount from the net income of Trust A. Lucas will be required to include $500,000 of the payment he receives in his assessable income for the 2010-11 income year (subject to the distributable surplus of Willis Pty Ltd).

When Lucas receives the payment from Trust A, he immediately loans the amount back to the trust for $4.5 million. The trust is obliged to repay the loan over successive income years.

In the 2012-13 income year, Willis Pty Ltd holds an unpaid present entitlement of $500,000 from the net income of Trust A. The trustee of Trust A again makes a payment of $500,000 to Lucas. However, this payment represents a repayment of the outstanding loan to Lucas, rather than a payment in relation to an unrealised gain.

Before the 2009-10 income year, Lucas would not have been required to include this payment in his assessable income under section 109XB. However, from the 2009-10 income year the subsequent payment made by the trustee (the repayment of the loan) is treated as the discharge of a present entitlement of the shareholder (or their associate) that is wholly or partly attributable to an amount that is an unrealised gain.

Definition of non-commercial loans

1.67 The definition of non-commercial loans in section 109Y currently includes the amounts that are shown as assets in the company's accounting records at the end of the year of income that have been taken under section 109D, section 109E and former section 108 to have been paid as dividends in earlier years of income.

1.68 These amendments allow amounts that have been included in the assessable income of a shareholder (or their associate), under section 109XB (about payments taken to be made through interposed entities), to be taken into account when determining the amount of non-commercial loans under section 109Y . [Schedule 1, item 28, subsection 109Y(2)]

1.69 Where an amount is included in the non-commercial loan calculation because of section 109XB, it will be reduced by the total of the unfranked parts of any later dividends received by a shareholder (or their associate) which have been set off under section 109ZCA. Subsection 109Y(2A) ensures that the amount of any non-commercial loans, for the purpose of section 109Y, does not result in an underestimate of an entity's distributable surplus . [Schedule 1, item 30, subsection 109Y(2A)]

Loans which have been treated as a deemed dividend that are forgiven by a trustee

1.70 Section 109G sets out that a private company is not taken to pay a dividend at the end of a year of income because of the forgiveness of an amount of a debt resulting from a loan, where the loan has already given rise to a deemed dividend. Currently, there is no equivalent provision in the law to allow a forgiven amount to be disregarded if the loan is made by a trustee rather than a private company.

1.71 These amendments introduce section 109XD, which allows an amount of a debt, resulting from a loan, to be forgiven and not be included in the assessable income of a shareholder (or their associate) of a private company where the loan has previously resulted in an amount being included in the assessable income of the shareholder (or their associate) under section 109XB or former section 109UB . [Schedule 1, item 24, section 109XD]

Example 1.19

Anna is a shareholder of Elliot Pty Ltd. In a previous income year, Anna received a non-Division 7A compliant loan from the Dawson Trust that was included in her assessable income under section 109XB.

In the 2009-10 income year, the Dawson Trust forgives the amount of the loan made to Anna. As the loan has already been included in Anna's assessable income under section 109XB, she is not required to include it again in her assessable income.

The offset of later dividends against loans made by trustees

1.72 The current law sets out special rules which allow a later dividend, distributed by a private company to a shareholder (or their associate), to be set off against some or all of an amount that has already been taken to be a deemed dividend, previously paid by a company.

1.73 However, where an amount is instead included in the assessable income of a shareholder (or their associate) under section 109XB, there is no corresponding provision in the law to allow a later dividend from a private company to be set off against this amount.

1.74 These amendments allow for later dividends, distributed by a private company to a shareholder (or their associate), to be set off against some or all of an amount received from a trustee, where that amount has already been included in the assessable income of the shareholder (or their associate) under section 109XB . [Schedule 1, item 31, subsection 109ZCA(1)]

1.75 As a later dividend could be part of a general dividend paid by the private company, and the dividend could be either fully or partly franked, an exception is provided so that a later dividend is still considered to be assessable income to the extent that it is franked . [Schedule 1, item 31, subsections 109ZCA(2) and (3)]

1.76 This exception means that the franking credit attached to a later dividend is still available to shareholders, to be applied against income tax liabilities, where that franked dividend is used to offset an earlier amount treated as a dividend . [Schedule 1, item 31, subsection 109ZCA(4)]

Repayment of a loan by withholding amounts from an employee's salary or bonus

1.77 Under section 109R some repayments made to a private company, in relation to a loan the private company made to an entity, are not taken into account for the purpose of working out how much of the loan has been repaid for the purposes of sections 109D and 109E or the minimum yearly repayment amount in subsection 109E(5).

1.78 Subsection 109R(2) determines which payments will not be taken into account, subject to the exceptions contained in subsection 109R(3).

1.79 Paragraph 109R(3)(b) provides an exception for a payment made by setting off a loan amount against work and income support related withholding payments and benefits payable by the private company. Paragraph 109R(3)(ba) provides an exception for payments covered by section 12-55 of Schedule 1 to the Taxation Administration Act 1953. Currently, the exceptions in paragraphs 109R(3)(b) and 109R(3)(ba) cannot be accessed if the repayment being made is for a loan from a trustee, due to the operation of subsection 109XC(8).

1.80 These amendments allow a loan made by a trustee to be repaid by setting off the payments outlined in paragraphs 109R(3)(b) and 109R(3)(ba) against the outstanding amount of the loan . [Schedule 1, item 23, subsection 109XC(8)]

Example 1.20

In the 2009-10 income year, Aaron is an employee of the Bell Trust but also a shareholder of Evans Pty Ltd. Evans Pty Ltd has an unpaid present entitlement to an amount from the net income of the Bell Trust.

During the 2009-10 income year, the Bell Trust makes a loan of $100,000 to Aaron. Aaron arranges for the Bell Trust to set off Aaron's yearly bonus against the outstanding loan as a repayment.

The amount that has been set off is treated as a repayment for the purposes of sections 109D, 109E and subsection 109E(5).

Repayment of a loan to a private company using a re-borrowing

1.81 Subsection 109R(2) currently states that a payment to repay a loan to a private company must not be taken into account if a reasonable person would conclude that, after having regard to all the circumstances, the entity making the repayment intended to obtain a loan from the private company of an amount similar to, or larger than, the repayment when the payment was made to the private company.

1.82 These amendments extend the operation of subsection 109R(2) to ensure that where a reasonable person would conclude that an entity obtained a loan from the private company, of an amount similar to, or larger than the payment, before the payment was actually made, the payment will not be taken into account for the purpose of working out how much of the loan is repaid under sections 109D and 109E, or the minimum yearly repayment amount under subsection 109E(5).

1.83 In certain circumstances, it may already be possible to disregard these payments. However, these amendments will put this matter beyond doubt and remove any ambiguity . [Schedule 1, item 15, subsection 109R(2)]

Example 1.21

Alicia obtains a loan of $10,000 from Cleary Pty Ltd. Alicia has until the lodgment day to repay the loan. Two weeks before the lodgment day Alicia obtains a further $10,000 from Cleary Pty Ltd. She then repays the original $10,000 loan a week before the lodgment day.

The repayment of the original $10,000 loan is not a repayment for the purposes of section 109D, because Alicia has borrowed a similar amount from Cleary Pty Ltd and in this case a reasonable person would conclude that the loan was obtained in order to make the repayment of the original $10,000.

The original $10,000 loan is treated as a deemed dividend subject to the distributable surplus of the private company.

Inclusion of Division 7A amounts in distributable surplus calculation

1.84 The current law does not include amounts that have been paid out by a private company in the form of a payment or a forgiveness of debt during an income year in the distributable surplus calculation made under subsection 109Y(2).

1.85 By excluding these amounts, the current formula in subsection 109Y(2) understates the distributable surplus of a private company. This may lead to an artificial reduction in the amount of deemed dividends that a private company is considered to have paid during the relevant income year.

1.86 These amendments correct this anomaly by including a reference to Division 7A amounts in the distributable surplus formula in subsection 109Y(2). This reference ensures that amounts that have been taken to be payments, under section 109C or the forgiveness of a debt under section 109F, are included in the distributable surplus of a private company under subsection 109Y(2) . [Schedule 1, item 27, subsection 109Y(2)]

Example 1.22

On 29 June 2005, a private company has real property valued at its historical cost in the company's accounting records of $500,000, which it acquired before 1985. The real property has a market value of $1,500,000 and the private company has liabilities of $400,000 and paid-up capital of $100,000. For section 44 purposes, the private company has 'profits' of $1,000,000 which reflects the unrealised gain in the real property.

If, on 29 June 2005, the private company makes an in specie distribution of the real property to a shareholder, an amount of $1,000,000 would be included in the shareholder's assessable income as a dividend under section 44.

However, if instead of making the in specie distribution, the private company sells the real property to the shareholder for $500,000, the sale of the real property is a payment within the meaning of paragraph 109C(3)(c) of an amount determined under subsection 109C(4) - being $1,000,000.

The private company's distributable surplus under section 109Y is determined according to the private company's accounting records as at 30 June 2005. As at that date, the private company has assets of $500,000 (being the proceeds on disposal of the real property), liabilities of $400,000 and paid-up capital of $100,000. The net assets of the private company for section 109Y purposes is $100,000 and the private company's distributable surplus after deducting paid up share capital of $100,000 is nil before these amendments. The end result is no amount is treated as a dividend under Division 7A.

By selling the real property to the shareholder at its historical cost, the private company has achieved a disguised distribution of $1,000,000 to the shareholder tax free.

If this same transaction occurs from the 2009-10 income year after these amendments, the amount of the payment for the purpose of paragraph 109C(3)(c) will be included in the distributable surplus of the private company as a Division 7A amount. Hence, the company's distributable surplus will be $1,000,000 and the shareholder of the company will be required to include a deemed dividend of $1,000,000 in their assessable income.

Application of Division 7A to a resident shareholder or their associate

1.87 There has been some conjecture as to whether Division 7A applies to circumstances where a shareholder of a private company (or their associate) is an Australian resident and the private company involved in the arrangement is a foreign resident.

1.88 Section 109BC will put beyond doubt that Division 7A applies in relation to these arrangements and that the Australian resident will be liable to pay tax on any deemed dividends that arise under the operation of Division 7A.

1.89 Subsection 109BC(1) ensures that the relevant tax accounting period for a foreign company applies for the purposes of Division 7A. Subsection 109BC(2) ensures that where a company is resident in more than one foreign country the tax accounting period that ends first will be the relevant tax accounting period for the purpose of Division 7A . [Schedule 1, item 11, section 109BC]

Application and transitional provisions

1.90 These amendments apply from 1 July 2009 . [Schedule 1, item 35]