Senate

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 9 - Distributions from private companies

Overview

9.1 Part 1 of Schedule 9 of the Bill will insert new Division 7A , of the Income Tax Assessment Act 1936 (the Act) to ensure that all advances, loans, and other credits (unless they come within specified exclusions) by private companies to shareholders (and their associates), are treated as assessable dividends to the extent that there are realised or unrealised profits in the company. In addition, debts owed by shareholders (or associates) which are forgiven by private companies are treated as dividends.

Summary of the amendments

Purpose of the amendments

9.2 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.

Date of effect

9.3 The amendments will apply (with certain exceptions) to all payments or loans made on or after 4 December 1997, the day the legislation was introduced into the Parliament (the introduction day) [subitem 7(1)] . Thenew measures will also apply to debts forgiven on or after the introduction day, regardless of when the debts were created [subitem 7(1)] . Where the terms of existing loans are varied on or after 4 December 1997, the amendments will deem such loans to be new loans from the day the terms are varied [subitem 7(2)] .

9.4 Certain amendments will apply only after 4.00 pm, by legal time in the Australian Capital Territory, on 27 March 1998. They are amendments that provide for:

•

the treatment, as a loan by a private company, of a loan by a trustee of a trust estate to a shareholder (or associate) of a private company when that company is, or has been, presently entitled to income of the trust estate which has not been paid to the company by the trustee;

•

the treatment of a presently existing liability incurred by a private company as a result of providing a guarantee or security for a loan made by an entity to a shareholder (orassociate) as a payment by the company to the shareholder (orassociate);

•

the conferring on the Commissioner of Taxation of the power to disregard the treatment of a loan guaranteed or secured by a private company as a payment by the company to a shareholder (or associate) if to do so would cause undue hardship for the shareholder (or associate); and

•

the treatment of a loan guaranteed or secured by a private company as a payment by that company to a shareholder (or associate) to the extent that a payment or loan made to a shareholder (or associate) by an interposed private company exceeds that interposed companys distributable surplus.

[Subitem 7(3)]

9.5 The amendments inserting a reference to new Division 7A into subsections 160AEA(1) and 160APA apply for the year of income in which the introduction day occurs, and later years of income. New section 160AQCNC, which provides for a company's franking account to be debited in relation to amounts treated as dividends under new Division 7A, also applies for the year of income in which the introduction day occurs, and later years of income. [Item 8]

9.6 New paragraph 268-40(5)(d) , which ensures that amounts taken to be dividends are properly attributed for the purpose of the trust loss measures, applies to dividends taken to be paid under new Division 7A on or after the introduction day. [Item 9]

9.7 The amendment removing amounts treated as dividends under new Division 7A from the application of the fringe benefits tax law applies from the year of tax in which the introduction day occurs and later years of tax. [Item 12]

Background to the legislation

9.8 Section 108 of the Act is an anti-avoidance provision intended to prevent private companies distributing profits to shareholders and their associates tax free, in the form of loans or other advances. The section also operates to capture amounts paid or credited on behalf of an associated person, while transfers of property are treated as if they were payments of amounts equal to the value of the property.

9.9 Such an amount is deemed to be a dividend and included in assessable income by virtue of subsection 44(1). Paragraph 44(1)(a) includes in the assessable income of a shareholder in a company, 'dividends paid to him by the company out of profits derived by it from any source'. The deemed dividend is not subject to dividend withholding tax (payable on dividends to non-residents) and is unfrankable (that is, it cannot carry imputation credits to allow a rebate to the recipient for company tax paid).

9.10 The existing provision dealing with private company loans etc, section 108, operates only when the Commissioner forms the opinion that the amount loaned, paid or otherwise credited, represents a distribution of profits. In order to be in a position to form this opinion, the Commissioner needs to consider many factors and analyse much information, which usually will not be available unless the Commissioner conducts an audit. Consequently, many loans which should be taxable as dividends are not so taxed.

9.11 The Treasurer in the 1997-98 Federal Budget announced on 13May 1997 that the new measures will operate automatically to deem advances, loans and amounts otherwise credited by private companies to shareholders (and their associates) to be assessable dividends to the extent that there are realised or unrealised profits in the company. The new provisions will not affect loans that are specifically excluded.

9.12 The Assistant Treasurer, by press releases issued on 9 and 27 March 1998, announced changes to the amendments to improve certainty in the application of the provisions and to prevent unintended consequences that might have otherwise occurred. Also announced were certain amendments intended to prevent Division 7A being circumvented.

Explanation of the amendments

9.13 Item 1 inserts new subsection 108(2AA) to ensure that section 108 of the Act does not apply to amounts paid or credited by a private company that are treated as dividends under the new Division 7A . Section108 may have application to loans which were in existence at the date of introduction of the new legislation. The section may also apply to loans made to a shareholder which is a company, other than in its capacity as a corporate trustee, or to loans made in the ordinary course of the private company's business on arm's length terms.

Subdivision A - Overview of this Division

9.14 The Division treats three kinds of amounts as dividends paid by a private company. As explained in new Subdivision B, these include payments made to a shareholder or shareholder's associate [new section 109C] , loans to a shareholder or associate [new section 109D] , and debts owed by a shareholder or associate that are forgiven by the company [new section 109F] .

9.15 The amendments will ensure that all amounts lent or paid and amounts of debts forgiven by private companies, are treated as dividends and are assessable income of the shareholder or associate under section 44 of the Act. The amounts treated as dividends will not be frankable, but will result in a debit to the company's franking account, to discourage dividend streaming. However, not all amounts paid or lent or debts forgiven are treated as dividends. This is explained in new Subdivisions C and D .

9.16 New Subdivision E explains when an amount paid or lent by one or more interposed entities to a shareholder or shareholder's associate will be treated as a dividend paid by the private company to the shareholder or associate.

9.17 New Subdivision F deals with the general rules applying to amounts treated as dividends. A loan can be deemed to be a dividend only to the extent of the distributable surplus (as calculated under new subsection 109Y(2) ) of the company. [New section 109Y]

9.18 New Subdivision G lists defined terms used in the Division.

Subdivision B - Private company payments, loans and debt forgiveness are treated as dividends

Payments treated as dividends

9.19 Generally, all payments made by a private company to a shareholder or associate are treated as dividends at the end of the private company's year of income [new subsection 109C(1)] . The shareholder or associate need not be a shareholder or associate at the time the payment is treated as a dividend if the amount was paid because the entity was a shareholder or associate.

9.20 A payment is defined in new subsection 109C(3) as:

•

a payment to the extent that it is made to a shareholder or associate; or

•

a payment to the extent that it is made on behalf of a shareholder or associate; or

•

a payment to the extent that it is for the benefit of a shareholder or associate; or

•

an amount to the extent that it is credited to a shareholder or associate; or

•

an amount to the extent that it is credited on behalf of a shareholder or associate; or

•

an amount to the extent that it is credited for the benefit of a shareholder or associate; or

•

a transfer of property to a shareholder or associate.

9.21 An amount which comes within the definition of loan in new subsection 109D(3) is expressly excluded from the meaning of payment [new subsection 109C(3A)].

9.22 The amount of the payment that is taken to be a dividend is the amount paid, subject to there being a distributable surplus in the company at the time. [New subsection 109C(2)]

9.23 The amount that is treated as a dividend where property is transferred is equal to the difference between the arm's length value of the property and any consideration that may have been given by the transferee in respect of the transfer. [New subsection 109C(4)]

When are loans treated as dividends?

9.24 Generally, loans made by private companies to shareholders or their associates will be treated as dividends, with some exceptions that are explained in new Subdivision D .

9.25 A loan is defined by new subsection 109D(3) to include:

•

an advance of money;

•

a provision of credit or any other form of financial accommodation;

•

an amount paid for, on account of, on behalf of, or at the request of, a shareholder or shareholder's associate, if there is an express or implied obligation to repay the amount;

•

a transaction that in substance effects a loan of money.

9.26 A loan is taken to have been made in the year of income in which a private company pays or credits an amount to the shareholder or associate by way of loan. [New subsection 109D(4)]

9.27 New section 109D explains the circumstances in which a loan will be treated as a dividend. Where a private company makes a loan to a shareholder or associate in a year of income (other than a loan made in the course of the winding-up of a company) and the loan is not fully repaid by the end of that income year, the loan will be treated as a dividend, provided new Subdivision D does not apply. Where a loan is made in the course of the winding-up of a company, the loan will be treated as a dividend if the loan is not repaid by the end of the year of income immediately following the year of income in which the loan is made [new subsection 109D(1A)] . Further, when the loan is made, the recipient must be either a shareholder in the private company or an associate of such a shareholder, or has been a shareholder or associate at some time and the loan is made because of that fact.

9.28 The amount that is treated as a dividend is the amount of the loan that has not been repaid at the end of the year in which it is made or, in the case of a winding-up loan, at the end of the year immediately following the year of income in which it is made, subject to there being a distributable surplus in the company. [New subsection 109D(2)]

9.29 As a general rule, existing loans will not be affected by the new rules. However, where a loan in existence at 4 December 1997 is varied on or after that day, either by extending the term of the loan or increasing the amount of the loan, new subsection 109D(5) will treat the loan as if it were a new loan entered into on the day it is varied.

Amalgamated loans

9.30 Loans (other than winding-up loans for the purposes of new subsection 109D(1A) ) which have the same maximum term (for the purposes of new section 109N ) made during the same year of income which are not treated as dividends at the end of that year are brought together to form a single amalgamated loan at the end of that year. In the second and subsequent years, it will then be necessary to make a minimum yearly repayment in respect of this amalgamated loan. Repayments made towards any of the constituent loans that make up the amalgamated loan will be treated as a repayment of the amalgamated loan. [New subsection 109E(4)]

9.31 If:

•

the amalgamated loan is not fully repaid; and

•

the minimum yearly repayment required under new subsection 109E(5) has not been made towards the amalgamated loan; and

•

the Commissioner has not exercised his/her power to disregard the failure to make the minimum yearly repayment [new section 109Q] ,

then the total sum outstanding at the end of the year of income in which the minimum yearly repayment is not made is treated as a dividend in that year of income [new subsections 109E(1) and (2)] , provided the company has a distributable surplus.

9.32 Amalgamated loans made to a shareholder or associate are not treated as dividends in the year in which the amalgamation occurs. [New section 109P]

Minimum yearly repayment

9.33 The minimum yearly repayment is worked out using the formula at new subsection 109E(6) . This formula may be altered by way of regulation.

9.34 The formula for the minimum yearly repayment calculates the annual repayment of principal and interest required to repay the amalgamated loan over the maximum term for amalgamated loans of that type. For example, if the amount of the amalgamated loan is $100,000, the term of the loan is five years, the remaining term of the loan is also 5 years and the benchmark interest rate is 8%, the minimum yearly repayment in the year immediately after the year in which the amalgamated loan comes into existence is calculated as follows:

(100,000 * 0.08) / (1 - ((1/(1+0.08))^5)) = $25,045


9.35 The term of the amalgamated loan is the longest term of any of the loans which make up the amalgamated loan. The remaining term of the loan is the difference between the number of years in the term of the loan less the number of years the loan has already been in existence. If the result is not a whole number then it is rounded up.

9.36 In order to calculate the minimum yearly repayment for the second or subsequent year, the borrower has to know how much of the repayment made in the first year is attributable to interest and how much is applied to reduce the principal. To calculate this the borrower may apply the relevant benchmark interest rate to the amounts outstanding from time to time in the year [new subsection 109E(7)] . The amount of the loan repaid during a year is obtained by deducting the amount of interest calculated under this formula from the actual repayment made during the year. The opening balance for the next year is the difference between the opening balance at the beginning of the previous year less the principal repaid during that year.

Forgiven debts treated as dividends

9.37 New section 109F contains the provisions that deal with debt forgiveness in relation to all shareholders and their associates. These provisions deal with the forgiveness of loans by private companies that have not been treated as dividends. The section will apply to debts forgiven on or after 4 December 1997, regardless of when the debts arose.

9.38 If a private company forgives, wholly or partly, a debt owed to it by a shareholder or associate, the amount forgiven will be treated as a dividend at the end of the private company's year of income, provided there is a distributable surplus in the company for that year of income [newsubsection 109F(2)] . New section 109F can apply where the shareholder or associate is not a shareholder or associate at the time when the debt is forgiven [new subsection 109F(1)] .

9.39 A debt is forgiven for the purposes of this Subdivision when the amount would be forgiven under section 245-35 (except subsection 245-35(4)) of Schedule 2C of the Act [new subsection 109F(3)] . It is important to also note that a reference to a debt includes part of a debt (subsection 245-245(1)).

9.40 Essentially, a debt is forgiven when:

•

the debtor's obligation to pay the debt is released, waived or otherwise extinguished (subsection 245-35(1)). "Extinguished" is defined in subsection 245-245(1) to exclude debts fully paid in cash. For the purposes of this Subdivision "extinguished" also excludes debts fully paid in property when the arm's length market value of the property is equal to or greater than the amount of the loan.

•

a creditor loses its right to sue the debtor for the recovery of the debt, due to the operation of a statute of limitations. In such cases, the debt will be treated as forgiven at that time. (subsection 245-35(2))

•

a debtor is effectively released from the obligation to pay the debt notwithstanding the existence of arrangements which imply that the debt remains on foot (subsection 245-35(3)). Under some arrangements, the debtor's obligation to pay the debt may not cease immediately but at some time in the future. Nevertheless, the debt will be treated as forgiven immediately if the debtor and creditor are not acting at arm's length and they agree either that the debtor will not have to pay any consideration for the concessions granted by the creditor, or will be required to pay merely a token amount. The agreement or arrangement need not be legally enforceable. Note also that a debt which is treated as forgiven because of such an arrangement would not be subject to the debt forgiveness provisions again when the debt is actually forgiven. To have the provisions apply upon actual forgiveness would result in double taxing of the debtor on the same amount.

9.41 If the same debt is taken to be forgiven under more than one provision, new section 109F only applies to the first forgiveness [new subsection 109F(8)] . For example, a debt could have been forgiven under new subsection 109F(6) because a reasonable person would conclude that payment was not going to be required, and forgiven again under new subsection 109F(3) because a statute of limitations came into effect, preventing recovery of the amount. In that case, only the first forgiveness under new subsection 109F(6) would be treated as a dividend.

Debt forgiveness by debt parking

9.42 A debt will also be deemed to be forgiven if the debtor enters into a "debt parking" arrangement [new subsection 109F(4)] . Essentially, debt parking refers to circumstances where:

•

the private company assigns its rights under a debt to a third party (the new creditor) without the debtor's obligations under the debt being forgiven and

-

the new creditor is an associate of the debtor; or

-

is a party to an arrangement with the debtor in relation to the assignment; and

•

a reasonable person would conclude (having regard to all the circumstances) that the new creditor will not exercise the assigned right.

9.43 When this type of debt parking arrangement occurs, the debt forgiveness provisions of Division 7A apply as if the debt had been forgiven.

Subdivision C - Forgiven debts that are not treated as dividends

9.44 Where a debt owed by a company is forgiven, it will not be treated as a dividend unless the company owed the debt in its capacity as a trustee. [New subsection 109G(1)]

9.45 Where a debt is forgiven because the shareholder or the shareholder's associate has either become bankrupt or has entered into a Part X deed of arrangement, deed of assignment, or a composition under the Bankruptcy Act 1966 , the amount forgiven will not be treated as a dividend. [New subsection 109G(2)]

9.46 If a loan which has been treated as a dividend under new sections 109D or 109E or existing subsection 108(1) in the current year or a previous year is forgiven, that forgiveness will not be treated as a dividend. [New subsection 109G(3)]

Commissioner may treat forgiveness as not giving rise to dividend

9.47 The Commissioner has a power to exclude a forgiven debt from the operation of this Division where the Commissioner is satisfied that the shareholder or associate would suffer undue hardship. In exercising his power, the Commissioner will take into account the ability of the shareholder or associate to repay the loan at the time it was granted, at the time it was forgiven and at any foreseeable future time. The Commissioner will only exercise his power if he is satisfied that the shareholder had the ability to pay at the time of receipt of the loan and lost the ability to pay, permanently, through no fault of his or her own.

Subdivision D - Payments and loans that are not treated as dividends

9.48 This Subdivision sets out rules for determining when payments and loans are not treated as dividends, and when repayments are not taken into account. [New section 109H]

9.49 An amount paid to discharge a pecuniary obligation owed by a private company to a shareholder or associate will not be treated as a dividend to the extent that the payment is not more than the amount the pecuniary obligation would have been if the private company and shareholder or associate had been dealing with each other at arm's length [new section 109J] . This section ensures that such commercial dealings are not unfairly taxed and that, for example, disguised distributions are not made by inflating the amount of a debt owed to a shareholder or associate by a private company.

9.50 A payment or loan made to another company (other than a company acting in the capacity of a trustee) is not treated as a dividend for the purposes of new sections 109C and 109D [new section 109K] . However, if the recipient company pays or loans an amount to a shareholder or associate of the company which makes a payment or loan, that payment or loan would generally be treated as a dividend [new SubdivisionF] .

9.51 If a private company makes a loan in the ordinary course of its business on the usual terms which it applies to arm's length loans of a similar type, that loan is not treated as a dividend. [New section 109M]

9.52 To the extent that a payment or loan made by a private company to a shareholder or associate forms part of the assessable income of the shareholder or the associate by virtue of some other provision of the Act, the payment or loan is not treated as a dividend [new subsection 109L(1)] . Also, a payment or loan made by a private company to a shareholder or associate is not treated as a dividend to the extent that the payment or loan is specifically excluded from the assessable income of the shareholder or the associate by a provision of the income tax law (other than the new Division 7A) [new subsection 109L(2)] .

9.53 Liquidators distributions and loans made in the course of the winding-up of a private company that are repaid by the end of the companys year of income following the year in which the loan is made are not treated as dividends. [New section 109NA] .

9.54 A loan to a shareholder (or associate of a shareholder) madeby a private company solely for the purpose of allowing the shareholder or associate to acquire qualifying shares or qualifying rights in the company under an employee share scheme to which existing Division 13A of Part III of the Income Tax Assessment Act 1936 would apply is not treated as a dividend. [New section 109NB]

Loans meeting criteria for minimum interest rate, maximum term and minimum repayment not treated as dividends

9.55 New section 109N specifies the criteria that allow certain loans not to be treated as dividends for the purposes of this Division. For this exception to be available, new subsection 109N(1) requires that:

•

the loan be made under a written agreement (a transitional rule will apply for the 1997-98 year of income which will permit taxpayers to satisfy this requirement by have a written loan agreement in place by 30 June 1998 [item 10] );

•

the rate of interest payable on the loan for years of income after the year in which the loan is made is equal to or exceeds the Indicator Lending Rates - Bank variable housing loan interest rate last published by the Reserve Bank of Australia before the start of the year of income [new subsection 109N(2)] . This rate is published monthly in the Reserve Bank of Australia Bulletin. This may be altered by regulation.

•

the maximum term for a secured loan be no more than 25 years and, for all other loans, no more than 7 years [new subsection 109N(3)] . For a secured loan, the amount of the loan cannot exceed 91% of the value of the property over which security is provided (less any other liabilities in respect of which the property also provides security). This loan must be secured by way of registered mortgage. The maximum term of a loan may be altered by regulation.

Example

An unsecured loan for 2 years (that is, a maximum term of less than 7 years) to a shareholder during the companys 1997-98 year of income (ending 30 June 1998) will not be treated as a dividend under new section 109D , if it is made under a written agreement which specifies that:

•

the rate of interest payable for the 1998-99 year of income equals or exceeds the benchmark interest rate, the Indicator Lending Rates Bank variable housing loan interest rate last published by the Reserve Bank before 1 July 1998; and

•

the rate of interest payable for the 1999-2000 year of income equals or exceeds the benchmark interest rate, the Indicator Lending Rates Bank variable housing loan interest rate last published by the Reserve Bank before 1 July 1999.

There is no legislative requirement that interest be paid or payable under the loan in respect of the year of income in which the loan is first made.

When may the Commissioner allow amalgamated loans not to be treated as dividends?

9.56 The Commissioner has a power to disregard the failure to make a minimum yearly repayment if the failure was caused by circumstances beyond the control of the shareholder or associate, and the inclusion of a dividend in the assessable income of the shareholder or associate would cause undue hardship to the shareholder or associate [newsubsection 109Q(1)] . In deciding whether to exercise this power, the Commissioner must have regard to the following factors:

•

whether the shareholder or associate had the capacity to repay the loan at the time it was granted;

•

any circumstances that reduced the capacity of the shareholder or associate to repay in the particular year of income;

•

whether the shareholder or associate has made a genuine attempt during that year to make the minimum yearly repayment; and

•

whether the shareholder or associate has made the later year's minimum yearly repayment and has also paid the amount outstanding from the previous year [new subsection 109Q(2)] .

9.57 This power might be exercised if a shareholder or associate is in severe financial distress; for example, where the shareholder or associate has been involuntarily retrenched from his or her employment.

9.58 A request for the exercise of the Commissioner's power to disregard the requirement to make a minimum yearly repayment may be lodged with the Commissioner at any time. However, depending on the circumstances, the Commissioner may not exercise the power in favour of the taxpayer. Therefore, prior to the exercise of the power, any return lodged in respect of a year in which the minimum yearly repayment was not made would have to be prepared on the basis that the amalgamated loan is treated as a dividend.

Repayments with the intention of reborrowing

9.59 Certain repayments which might otherwise be taken into account in determining whether a loan has been repaid in whole or in part in the year in which it was made, or in determining whether a minimum yearly repayment has been made, will be disregarded. [New subsection 109R]

9.60 Repayments will be disregarded if a reasonable person would conclude, on the basis of all relevant circumstances, that the shareholder or associate objectively intended to reborrow a similar or larger sum from the same private company [new subsection 109R(2)] . This provision is intended to prevent shareholders or associates from avoiding the operation of the Division by temporarily repaying a loan.

9.61 A repayment will be taken into account in determining whether a loan has been repaid in whole or in part in the year in which it was made, or in determining whether a minimum yearly repayment has been made, even if there is an intention to reborrow, to the extent that the loan is offset by:

•

payments sourced from a dividend payable to the shareholder by the private company

•

payments sourced from the PAYE earnings of the borrower (eg.salary and bonus etc.)

•

the difference between the arm's length value of property transferred to the private company and any consideration provided by the company for the property. [New subsection 109R(3)]

9.62 A payment made to the private company by a third party on behalf of a shareholder or associate will be treated as a repayment, provided the amount is owed by the third party to the shareholder or associate, and would be included in the assessable income of the shareholder or associate. [New subsection 109R(4)]

Subdivision E - Payments and loans through interposed entities

9.63 New Subdivision E applies to back-to-back arrangements under which a private company pays or loans an amount to an interposed entity on the understanding that the interposed entity or another interposed entity will pay or loan an amount to a shareholder of the private company or an associate of the shareholder. In such cases, the private company will be treated as having directly paid or loaned an amount to the shareholder or associate. The amount of the payment or loan will be determined by the Commissioner having regard to certain specified conditions.

Payments through interposed entities

9.64 A payment or loan from a private company will be treated as being made directly to a shareholder or associate if the following conditions are met:

•

the private company makes a payment or loan to another entity that is interposed between the private company and a shareholder or a shareholder's associate;

•

it is reasonable for a person to conclude that the sole or main purpose of the private company in making the payment or loan to the interposed entity was to enable an amount to be paid or loaned to a shareholder of the private company or a shareholder's associate; and

•

either the interposed entity or another entity interposed between the private company and the shareholder or shareholder's associate makes a payment or loan to the shareholder or shareholder's associate. [New subsection 109T(1)]

9.65 New subsection 109T(1) will apply regardless of whether the payment or loan from the interposed entity to the shareholder or shareholder's associate is made before, after, or at the same time as the payment or loan is made from the private company to the first interposed entity. [New paragraph 109T(2)(a)]

9.66 It is also irrelevant whether the amount paid or lent to the shareholder or shareholder's associate is different to the amount paid or lent from the private company to the first interposed entity. [Newparagraph 109T(2)(b)]

9.67 An amount will not be taken to be a dividend under new Subdivision E if the amount is otherwise taxable under new SubdivisionB [new subsection 109T(3)] . For example, an amount might be paid or lent to a shareholder or associate through an interposed entity which is also a shareholder or associate. In that case, the amount could be taxable to the interposed entity in its own right under new Subdivision B .

Payments and loans through interposed entities relying on guarantees

9.68 A guarantee of a loan will be treated as a payment for the purposes of new section 109T if a loan or payment is provided to a private company shareholder (or associate) by an interposed company that does not have a distributable surplus or has a distributable surplus less than the amount paid or lent to the shareholder (or associate) [new section 109U] .

9.69 If a guarantee is given by a private company (the first entity) as part of an arrangement involving, either directly or indirectly, a payment or loan to a shareholder (or associate) of that company by another company (the interposed company), some or all of that payment or loan may be treated as a payment by the first entity directly to the shareholder (or associate). Such an amount will generally be treated as a deemed dividend.

9.70 Without this rule, the intended effect of new Division 7A could be circumvented by structuring a loan to a shareholder (or associate) through a company which has no distributable surplus, the repayment of which is guaranteed or secured by a company with distributable profits. Under such an arrangement the loan or payment by the interposed company would not be treated as a dividend under new Division 7A because the company making the loan does not have a distributable surplus.

9.71 A similar result could also be achieved by using an interposed company with a distributable surplus that is less than the payment or loan made to the shareholder (or associate) of the first entity.

9.72 The amounts treated as paid by the private company to the shareholder under new section 109U will be determined by the Commissioner in accordance with new section 109V . The amount treated as a payment by the private company to the shareholder (or associate) is then reduced by the amount of the interposed companys distributable surplus (if any) adjusted to allow for any other loans, payments or debts forgiven by the interposed company that are treated (other than by this section) as dividends for the year of income [new subsections 109U(2) and (3)].

9.73 New section 109C will then apply to the resulting amount to treat it as a dividend paid by the private company to the shareholder (or associate).

9.74 The payment or loan by the interposed company, to the extent of the interposed companys distributable surplus, would be treated as a payment or loan by that company and, as such, may also be treated as a dividend according to new sections 109C or 109D .

9.75 New section 109U operates irrespective of whether the loan or payment by the interposed company occurred before or after the first entity provided the guarantee or security for a loan, and irrespective of whether the amount of the loan or payment by the interposed company is greater or less than the amount that has been guaranteed. [New subsection 109U(4)]

Certain liabilities under guarantees treated as payments

9.76 Other than in the circumstances to which new section 109U applies, a guarantee given by a private company for a loan by a third party to a shareholder (or their associate) is treated as a payment by the company directly to the shareholder (or associate) only where a liability (other than a contingent liability) is actually incurred by the private company as a result of providing the guarantee or security. [New section 109UA]

9.77 New section 109UA , in conjunction with new sections 109T , 109V , and 109C , will treat as a dividend the amount of any liability (other than a contingent liability) incurred by the company as a result of providing a guarantee or security for a loan made directly or indirectly to a shareholder (ortheir associate). The deemed dividend will arise in the year of income in which the private company which provided the guarantee first has a non-contingent liability under the guarantee. Normally, such a liability will result from a default by the borrower under the loan agreement in respect of which the guarantee was given.

9.78 An amount treated as paid by a private company to an entity under new subsection 109UA(1) will be determined by the Commissioner in accordance with new section 109V . Such an amount is then reduced by the amount (if any) treated as a dividend as a result of the operation of new section 109U [newsubsection 109UA(2)] .

9.79 New subsection 109UA(3) will provide a power to the Commissioner to disregard, for the purposes of new subsection 109UA(1) , a liability incurred by the company under a guarantee or security for a loan. Inexercising this power the Commissioner must have regard to the following criteria:

•

the inclusion of the amount treated as a dividend in the shareholders or associates assessable income would cause undue hardship; and

•

the shareholder or associate had the capacity to repay the loan when it was made.

9.80 This will give the Commissioner a power in circumstances where a shareholder (or associate) is financially unable to meet the payments through no fault of their own: for example, where a shareholder has been involuntarily retrenched from his or her employment. The power may also be exercised in the following situation.

Example

A private company guarantees a loan that a bank makes to a shareholder in the private company and that shareholder technically defaults under the loan agreement by failing to make a repayment by the due date. The shareholder makes the necessary repayment to the bank shortly after the due date, out of the shareholder's own funds. The bank does not call upon the company to meet is obligation under the guarantee and no payment is actually made by the company (or any of its associates) to the bank in respect of that guarantee.

9.81 To avoid any doubt, new subsection 109UA(4) provides that new section 109UA does not limit the operation of new section 109T , the general rule about payments and loans by a private company to an entity through one or more interposed entities.

Certain trust amounts treated as loans

9.82 New section 109UB will apply if a private company, as a beneficiary of a trust estate, is or has been presently entitled to some or all of the net trust income which has not actually been paid. In such a situation the amount to which the company is presently entitled is held on a secondary trust for the benefit of the company. The provision applies to any subsequent loan by the trustee to a shareholder (or associate) of the company.

9.83 The loan from the trustee is treated as a loan by the private company to the shareholder (or associate) of an amount not exceeding the amount of income held on trust for the company, reduced by any amounts previously treated as a loan by new section 109UB in relation to the trust amount. [Newsubsection 109UB(2)]

Amount of a payment through an interposed entity

9.84 A private company is taken to have made a payment to a shareholder or associate when the interposed entity makes a payment to a shareholder or associate. [New subsection 109V(1)]

9.85 The Commissioner will determine the amount of the payment made by the private company to the shareholder or associate having regard to:

•

the amount the interposed entity paid to the shareholder or the shareholder's associate; and

•

how much of that amount the Commissioner believes represented consideration (valued at arm's length) payable to the shareholder or the shareholder's associate or any of the interposed entities. [New subsection 109V(2)]

9.86 This provision allows the Commissioner to take into account such things as a payment from the interposed entity which was, in whole or in part, the arm's length consideration for the sale of goods or the provision of services to the interposed entity by the shareholder or associate.

Amount of a loan through an interposed entity

9.87 A private company is taken to have made a loan to a shareholder or an associate when the shareholder or associate receives a loan from an interposed entity. The amount lent by the private company to the shareholder or associate is referred to as the notional loan . [Newsubsection 109W(1)]

9.88 The Commissioner will determine the amount of the notional loan having regard to:

•

the amount the interposed entity lent to the shareholder or associate;

•

how much of that amount the Commissioner believes represents the arm's length consideration payable by the private company to the shareholder or associate or any of the interposed entities for the provision of goods or services. [New subsection 109W(2)]

9.89 When valuing the amount of the notional loan that is treated as a dividend under section 109D, any repayments made by the shareholder to the interposed entity are taken into account. Repayments of the notional loan are calculated as a proportion of the total loan repayment made to the interposed entity which is referable to the notional loan [new subsection 109W(3)] . An example is provided below:

The private company lends $100 to interposed entity B

Interposed entity B lends $150 to shareholder C

The Commissioner concludes that $100 of the $150 lent by entity B is the notional loan

A repayment of $21 is made by shareholder C to interposed entity B

$21 [repayment] * ($100 [notional loan amount] / $150 [actual amount lent])


Notional repayment = $14

9.90 A private company may be taken to have paid a dividend to a shareholder or associate even if:

•

the private company has made a payment or loan to another company which happens to be interposed between the private company and the shareholder or a shareholder's associate; or

•

some or all of the amount paid or lent by the private company to an entity interposed between the private company and the shareholder or a shareholder's associate is included in the interposed entity's assessable income for a year of income. [New subsection 109X(1)]

9.91 A notional loan cannot be: an excluded loan under new section 109N ; a part of the amalgamated loan for the purposes of new section 109E ; or treated as a loan made in the ordinary course of business under new section 109M . [New subsection 109X(2)]

Subdivision F - General rules applying to all amounts treated as dividends

9.92 New Subdivision F :

•

restricts the value of amounts taken to be dividends under new Division 7A to the company's distributable surplus [new section 109Y] ;

•

treats such amounts as being paid from company profits to the entity in its capacity as a shareholder [new section 109Z] ;

•

prevents the collection of withholding tax on such amounts [newsection 109ZA] ;

•

ensures that new Division 7A applies to such amounts in priority to fringe benefits tax (FBT), except in relation to payments to a shareholder (or associate) in their capacity as an employee or associate of an employee [new section 109ZB] ; and

•

deals with the taxation of dividends which are offset against amounts already taxed under the Division [new section 109ZC] .

Proportional reduction of dividends so that they do not exceed distributable surplus

9.93 Distributable surplus is the maximum amount that can be treated as dividends paid by the company under new Division 7A . If the value of amounts otherwise treated as dividends is greater than the company's distributable surplus, the taxable value of each dividend is recalculated to reflect the value of the distributable surplus [new subsection 109Y(1)] .

9.94 The calculation of a private company's distributable surplus at the end of its year of income is provided by new subsection 109Y(2) as:

net assets , being the amount (if any) by which the company's assets (as calculated in the companys books of account) exceed the sum of the present legal obligations owed by the company and the following provisions (as shown in the companys accounting records):

•

provision for depreciation;

•

provisions for annual leave and long service leave;

•

provision for amortisation of intellectual property and trademarks;

•

other provisions that may be prescribed in regulations;

less

loans which remain outstanding in the companys accounting records at the end of the year that have been treated as dividends in earlier years of income under new sections 109D or 109E or existing section 108;

less

the sum of the company's paid-up share capital and paid-up share premium account;

less

the total amount of repayments to the company of loans or amounts set off against loans that previously have been taken to be dividends under new sections 109D or 109E or existing section 108. This does not include amounts set off as a result of a dividend, to the extent that the amounts have not been franked under section 160AQF, where those amounts are not treated as dividends by subsection 108(2) or new section 109ZC . Amounts set off as a result of a loan, or part of a loan, being forgiven by the company are also not included.

9.95 If the Commissioner considers that the company's assets are significantly undervalued, or its provisions significantly overvalued, in the accounting records of the company, the Commissioner may substitute an appropriate value [new subsection 109Y(2)] .

9.96 If a company's distributable surplus is less than the amount it would otherwise be taken to have paid as dividends, the reduced amount of each dividend the company is taken to have paid is calculated by using the formula in new subsection 109Y(3) .

9.97 The formula divides the company's distributable surplus by the total value of dividends the company would otherwise have been taken to pay in the year of income (called the total of provisional dividends). The resulting fraction is applied to each dividend (provisional dividend) to calculate the taxable value. An example is provided below.

9.98 A private company has a distributable surplus of $90. The value of dividends it would otherwise be taken to pay is $100. Shareholder A was paid $50 which was taken to be a dividend under new section 109D . The amount on which shareholder A is liable to tax is calculated as:

$50 * (90/100)
= $50 * 0.9 = $45


9.99 A shareholder or associate who received an amount treated as a dividend would need to be informed if his or her dividend were reduced in this way, so that the correct amount could be declared in an income tax return. Therefore, if this section reduces the amount taken to be a dividend paid by a private company, the company must inform the shareholder or associate in writing of the company's distributable surplus and the amount otherwise taken to be paid as dividends [new subsections 109Y(4) and (5)] . This will provide the fraction to be applied to amounts otherwise taken to be dividends received by the shareholder or associate from the company.

Characteristics of dividends taken to be paid under this Division

9.100 Paragraph 44(1)(a) includes in the assessable income of a shareholder in a company, 'dividends paid to him by the company out of profits derived by it from any source'. New section 109Z ensures that paragraph 44(1)(a) applies to amounts treated as dividends under new Division 7A , by taking the dividend to be paid to the shareholder or associate in the capacity of a shareholder, and out of the private company's profits.

No dividend taken to be paid for withholding tax purposes

9.101 Dividends received by non-resident individuals are normally subject to withholding tax under Division 11A of Part III, which is collected under Division 4 of Part VI. However amounts treated as dividends under section 108 are not subject to withholding tax. Likewise, amounts treated as dividends under new Division 7A are not subject to withholding tax. [New section 109ZA]

Amount treated as dividend is not a fringe benefit

9.102 Fringe benefits tax (FBT) can apply to 'loan benefits' and 'debt waiver' benefits provided to employees and their associates. In the case of a private company, it may be that an employee of the company or an associate of an employee is also a shareholder or associate of a shareholder of the company. Thus a private company might be subject to FBT on an amount which is also treated as a dividend under new section 109D or 109F .

9.103 New section 109ZB avoids doubt as to which law prevails by providing that new Division 7A applies to a loan even if the amount could be a fringe benefit [new subsection 109ZB(1)] . This also applies to a forgiven debt [new subsection 109ZB(2)] .

9.104 Double taxation is avoided by providing that amounts taken to be paid to a shareholder or associate as a dividend under new Division 7A are excluded from the definition of fringe benefit contained in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 [item 11] . Thus a private company will not be subject to FBT on an amount taxed to a shareholder or associate under new Division 7A . This exclusion from FBT applies for the FBT year in which 4 December 1997 occurs and later FBT years [item 12] .

9.105 New subsection 109ZB(3) ensures that new Division 7A will not apply if a payment is made to a shareholder or associate in their capacity as an employee or associate of an employee. Thedefinition of employee is that which applies for the purposes of the Fringe Benefits Tax Assessment Act 1986 . This will mean that payments (including the transfer of property, such as mobile phones and laptop computers) to a shareholder (or associate) in their capacity as an employee or an associate of an employee will be subject to the provisions of the Fringe Benefits Tax Assessment Act 1986 and not Division 7A. It will also ensure that superannuation contributions made by a private company on behalf of a shareholder (or associate) who is an employee will not be subject to Division 7A.

Treatment of dividend used to offset an earlier dividend

9.106 As a general rule, if a dividend (referred to as the later dividend) is used to offset an amount that has already been subject to tax as a dividend under new Division 7A , that later dividend will not be taxed [newsection 109ZC] . If part of the later dividend is used to offset the earlier amount, the part which is offset will not be taxed.

9.107 The later dividend could be part of a general dividend paid by the private company. If this is the case, the dividend could be either fully or partly franked. Therefore, an exception to the general rule is provided, so that a later dividend would still be considered to be assessable income to the extent that it is franked. [New subsection 109ZC(2)]

9.108 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. [New subsection 109ZC(3)]

Subdivision G - Defined terms

9.109 A number of terms are used throughout new Division 7A , which are defined in that Division or in other parts of the income tax law, under either the 1936 or 1997 Income Tax Assessment Act . New section 109ZD provides references to these definitions.

9.110 New Division 7A provides definitions, for its purposes, for the terms:

•

amalgamated loan [new subsection 109E(3)] ;

•

benchmark interest rate for a year of income [new subsection 109N(2)] ;

•

distributable surplus [new subsection 109Y(2)] ;

•

forgive (a debt) [new subsections 109F(3) and (4)] ;

•

guarantee (used in new Subdivision E );

•

loan [new subsection 109D(4)] ; and

•

payment [new subsection 109C(3)] .

9.111 'Arrangement' and 'PAYE earnings' are given the meaning supplied by section 995-1 of the Income Tax Assessment Act 1997 (the 1997 Act). This subsection provides a reference list to the definitions contained in the 1997 Act. 'Entity' has the meaning given by section 960-100 of the 1997 Act. The interpretation rules applying to entities, which are contained in subsections 960-100(2), (3) and (4), also apply to new Division 7A [new section 109ZE] .

9.112 The term 'associate' is defined by section 318 of the Act. The reference to section 318 is also given in section 995-1 of the 1997 Act.

Franking of dividends

9.113 An amount treated as a dividend under new Division 7A cannot give rise to an imputation credit as it is not a frankable dividend [new paragraph (h) in the definition of "frankable dividend" in 160APA inserted by item 4] . Thus a shareholder or associate which receives an amount treated as a dividend under the Division is not entitled to a franking rebate to offset its income tax.

9.114 This could allow unfranked dividends to be streamed to particular shareholders or associates. Item 5 is intended to discourage this by inserting new section 160AQCNC which provides that a franking debit arises for a private company which is taken to have paid a dividend under the Division. The debit is calculated in the same way in which a franking debit is calculated in relation to a fully or partly franked dividend [new subsections 160AQCNC(2) and (4)] .

9.115 The creation of a franking debit and non-allowance of a corresponding credit will apply to amounts treated as dividends during the companys year of income in which 4 December 1997 occurs and later years of income. [Item 8]

Consequential amendments

9.116 Subsection 160AEA(1) defines 'passive income' for the purpose of Division 18 of Part III of the Act. Item 3 includes an amount taken to be a dividend in a year of income because of new Division 7A . The amendment applies for the year of income in which 4 December 1997 occurs and later years of income [item 8] .

9.117 Taxation Laws Amendment (Trust Losses and Other Deductions) Act 1998 inserted Schedule 2F into the Act to deal with the treatment of trust losses. Subsection 268-40(5) of the Schedule explains how to attribute assessable income between periods. Item 6 ensures that amounts treated as dividends under new Division 7A are attributed appropriately where dividends are taken to be paid on or after 4 December 1997 [item 9] .

9.118 Section 10-5 of the 1997 Act includes, in assessable income, amounts which are not ordinary income (through providing a list of such items which are specifically included). Item 13 includes amounts treated as dividends under new Division 7A of Part III by adding the Division to the list contained in section 10-5.

Regulation impact statement

Specification of policy objective

9.119 The purpose of this tax measure is to reduce the scope for tax avoidance by ensuring that tax is payable on distributions from private companies which take the form of loans which are not on commercial terms. Currently, private companies are, in certain circumstances, able to make distributions of realised or unrealised profits that are effectively tax free by structuring them as payments or loans to shareholders rather than as taxable distributions.

Identification of implementation options

Background

9.120 Private company dividends disguised as loans are currently addressed by section 108 of the Income Tax Assessment Act 1936 (the Act). Section 108 operates by deeming an amount to be a dividend where a private company lends, advances, or credits the amount to or on behalf of a shareholder or an associate of the shareholder. However, the section only deems so much of the amount to be a deemed dividend as in the opinion of the Commissioner represents a distribution of profits. The section relies on field audits to identify cases. Such audits have shown that it is difficult to determine whether section 108 applies to particular transactions and that the section does not always apply where it was intended to.

Implementation

9.121 The implementation of the Government's policy objective involves amending the tax law to strengthen section 108 of the Income tax Assessment Act 1936 . As a result of the amendments the following will be treated as dividends:

(a)

all loans, advances, transfers of property, or the crediting of amounts by private companies to shareholders or their associates unless they come within a defined class of excluded loans;

(b)

all debts owed by shareholders or their associates to private companies that are forgiven, provided the loan itself has not been previously taxed under the provisions; and

(c)

all loans, advances, transfers of property, or credits made to unrelated third parties, where there is an agreement that the third party will advance, credit or loan a similar amount to a shareholder or associate of a shareholder of the original lender.

9.122 A loan will be an excluded loan if the loan meets certain conditions. The conditions are that:

•

the loan agreement is in writing; and

•

interest is payable at a rate equal to or greater than the benchmark interest rate (same as for FBT purposes); and

•

the term of the loan is not greater than a specified maximum term for the loan; and

•

the amount payable in respect of the loan in a year of income is equal to or greater than either the specified minimum yearly repayment, or in the year of income in which the loan is discharged, the amount of the loan plus any outstanding interest payable in respect of the loan.

9.123 The new measures will be self-actuating and will have stricter application.

Assessment of impacts (costs and benefits)

Impact group identification

9.124 The proposed measure will impact on new payments and loans made by private companies on or after the date of introduction of the legislation into the Parliament, and to any existing loans where the term of the loan is extended or the amount of the loan is increased. It will also apply to any loans forgiven after the date of introduction.

9.125 These amendments will affect shareholders and their associates who receive loans and payments from private companies. Where the loans and payments are either "excluded", (eg a loan made on commercial terms which complies with the new legislation), or they are fully repaid in the year that they were advanced or credited, the provisions will have no effect, and therefore, no costs.

9.126 The measures will impact on approximately 56,000 private companies and a number of their shareholders who will incur costs in restructuring their affairs in ensuring they comply with the new legislation requirements. It is estimated that approximately one quarter of small businesses that operate through private companies make loans and payments to their shareholders. The measures will apply equally to these shareholders as they would to larger private companies that make loans and payments to their shareholders.

9.127 The measure will also have an impact on the Australian Taxation Office (ATO). Because the measure is self actuating there will be less need for audit activity to identify cases where the provision should apply. There will also be several discretions in the legislation, the application of which will require ATO resources.

Analysis of the costs and benefits associated with the self actuating approach

Compliance costs

9.128 The impact on compliance costs is not expected to be substantial, as most of the information or documentation required to comply with the proposed measures would already be kept in order to comply with existing company and taxation laws. Also, because loans that are considered to be commercial are excluded from the operation of the provisions, taxpayers can arrange their affairs accordingly. The initial costs associated with the operation of the new measures are also likely to be moderate, as the system will be relatively straightforward, both conceptually and legislatively.

9.129 It is expected that approximately one quarter of small businesses that are run through private companies would incur compliance costs associated with these measures. However, these taxpayers can reduce costs by ensuring that loans are either repaid before the end of the year in which they are made or that loans satisfy the criteria laid down in the legislation. Shareholders who do not currently repay loan accounts could incur costs in obtaining alternative finance. In those cases where the provisions do apply to deem loans to be dividends, there will be some minor costs associated with adjusting the company's franking account.

9.130 The total additional compliance costs relating to this proposal are expected to be approximately $3 million. These costs will be incurred as follows:

9.131 The compliance costs in 1996-97 relate to expenses that taxpayers would have incurred immediately following the Budget announcement.

9.132 The ongoing compliance cost is likely to be less than $1 million per year. These costs are in respect of expenses in obtaining tax advice on particular arrangements. This does not include the costs of some shareholders who rearrange their affairs to seek alternative sources of finance. There may also be some small costs in respect of taxpayers that have genuine loans, who may seek confirmation that their loans comply with the new legislation. It is reasonable to assume that genuine loans would be supported by a written loan agreement.

Benefits

9.133 The self actuating scheme will reduce the need for the Commissioner to conduct audits and as such the administrative costs to the ATO may fall.

9.134 In subsequent years, the measures will affect shareholders taking out loans for the first time. However, there should be compliance cost savings as the new requirements will result in outcomes that are more certain. A taxpayer will know at the end of each year whether loans or payments will be treated as dividends rather than there being a possibility that the Commissioner will later deem the loans to be dividends.

Taxation revenue

9.135 The measures will affect shareholders taking out loans for the first time after the introduction of the provisions. This measure will prevent loss of revenue in future years.

Consultation

9.136 Due to the sensitive nature of these proposals, external consultation was not undertaken prior to the announcement in the Federal Budget.

9.137 However, since the Budget, some external consultation has been undertaken with a number of professional bodies. Submissions received during the consultation period were considered in the course of finalising the legislation. The Government has accepted several suggestions made in those submissions. For example:

•

The maximum term for a secured loan will be 25 years and the maximum term for an unsecured loan will be 7 years.

•

The benchmark interest rate may be applied to daily loan balances in order to work out how much of the repayment is applied to reduce the principal of the loan.

•

The real property against which a loan has been provided may be used as a security for other loans provided the loans do not exceed 90% of the total value of the security at any time.

Conclusion

9.138 Currently, section 108 of the Act is not as effective as it should be in preventing private companies from distributing profits in the form of loans. It relies on the identification by the ATO of such loans, which will occur only in individual cases where there has been an audit or where there has been a voluntary disclosure of information. There are often significant costs to taxpayers involved in ATO audits and examinations.

9.139 The amended provisions will apply automatically, and as such, will place an increased burden on taxpayers to ensure they have complied with the rules. However, the Government believes that these costs are more than offset by the prevention of further revenue leakage.

9.140 The Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from professional and small business associations and through other taxpayer consultation forums.