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Introduction
Intra-family group Div. 7A loans and unpaid present entitlements (UPEs) represent a significant risk management issue for clients and advisors.
From 4 December 1997, a payment or a loan made or a debt forgiven directly or indirectly by a private company to a shareholder (or a shareholder’s associate) is a deemed unfranked dividend to the shareholder (or the shareholder’s associate) to the extent of the private company’s distributable surplus, unless exempt, fully repaid within the required time or the Commissioner exercises a discretion to ignore or modify the operation of the provisions in Div. 7A.
From 16 December 2009, the Commissioner changed administrative practice and considers that a UPE from a trust to a private company beneficiary which remains intermingled with the funds of the trust constitutes an ‘extended definition loan’.
Pre-4 December 1997 loans and pre-16 December 2009 UPEs were generally quarantined by advisors as being outside the scope of Div. 7A.
With effect from 1 July 2018, the 2016 Federal Budget announced amendments to Div. 7A adopting the recommendation of the Board of Taxation, which appears to bring quarantined pre-1997 loans and pre-2009 UPEs into Div. 7A (Budget Paper No. 2 page 42).
The inclusion of quarantined pre-1997 loans and pre-2009 UPEs into Div. 7A requiring repayment under the new Rule of 78 loan rules will renew investigations into forgiving or restructuring these amounts before 1 July 2018.
Legislative references are to the Income Tax Assessment Act 1936 (Cth) (ITAA 1936), the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) and the Limitation of Actions Act 1958 (Vic) (LAAV 1958).
Nature of loans and UPEs
A UPE may be a ‘loan’ but not a ‘debt’ for Div. 7A purposes and not a ‘loan’ at law or for other tax purposes, creating complexities in interpretation and management of loans and UPEs.
A loan is a contract by which the lender pays or advances money to the borrower in consideration of which the borrower agrees to repay the amount together with other money, such as interest (Foley v Hill (1848) 2 HLC 28; 9 ER 1002).
For Div. 7A purposes, the Commissioner considers that the concept of loan is extended to include a provision of credit or any other form of financial accommodation or a transaction which in substance effects a loan of money (sec. 109D ITAA 1936; TR 2010/3; PSLA 2010/4).
A UPE is not traditionally considered to create a loan or other debt relationship, because it is created by a present entitlement that becomes the absolute property of the beneficiary (Tindon P/L v Adams [2006] VSC 172; cf Chianti P/L v Leume P/L [2007] WASCA 270; Gustode P/L v Ashley [2011] FCA 250).
The Commissioner has asserted that a UPE is not a loan or other debt relationship for purposes other than Div. 7A (TR 2010/3 Div. 7A UPEs; TD 2015/D5 UPE Bad Debt deduction).
Div. 7A loan & UPE reforms
The standardisation of the 7 year (unsecured) and 25 year (secured) principal and interest complying loans and the 7 year (unsecured) and 10 year (unsecured) interest only UPE investment agreements to the common Rule of 78 Loan terms will significantly impact many clients.
The Board of Taxation, Post implementation Review of Division 7A…Report (November 2014) proposed:
- the statutory treatment of UPEs as loans for Div. 7A purposes
- the inclusion of quarantined pre-1997 loans and pre-2009 UPEs requiring repayment under the new loan rules
- an Amortisation Model for UPE and loans known as the Rule of 78 Loan
- grandfathering of 25 year secured complying loans existing before 1 July 2018
The grandfathering of 25 year loans entered into before 1 July 2018 will encourage refinancing to 25 year complying secure loans.
The inclusion of quarantined pre-1997 loans and pre-2009 UPEs requiring repayment under the new Rule of 78 Loan terms will renew interest in forgiving or restructuring these amounts before 1 July 2018 to manage potential cash flow problems with complying with loan payments.
The Rule of 78 Loan terms include:
1. a maximum 10 year loan
2. a fixed interest rate for the duration of the loan at the Reserve Bank of Australia indicator lending rate for small business variable (other) overdraft for May immediately preceding the start year (eg 9.20% at 30 June 2014)
3. principal must be repaid at least to prescribed maximum loan balances under the ‘Rule of 78’ being:
| Year 3 | 75% of the original loan |
| Year 5 | 55% of the original loan |
| Year 8 | 25% of the original loan |
| Year 10 | 0% fully repaid |
4. interest can be accrued and paid for the period at year 3, 5, 8 and 10
5. loan evidenced in writing but without need for a formal loan agreement
6. any shortfall in principal or interest would constitute a deemed dividend out of the distributable surplus for the breach year
7. deductibility of interest will be subject to the existing income tax rules
Forgiveness of pre-1997 loans
Some pre-1997 loans may have constituted a deemed divided outside the 4 year amendment period, so the Commissioner cannot assess the deemed dividend and the loans may be written off without current year tax consequences.
Where a private company is taken to have paid a deemed dividend outside the 4 year amendment period so the Commissioner cannot assess the deemed dividend (sec. 170 ITAA 1936), forgiveness of the loan (sec. 109G ITAA 1936) or the subsequent payment of the amount (sec. 109ZC ITAA 1936) is effectively exempt from Div. 7A and tax free.
A private company is taken to pay a dividend at the end of the current year if all or part of a debt owed to the private company is forgiven in the current year to a current shareholder (or a shareholder’s associate) or a past shareholder (or a past shareholder’s associate) where a reasonable person would conclude that the forgiveness occurred because of the shareholder or shareholder’s associate relationship (sec. 109F ITAA 1936).
A debt is forgiven if formally or effectively waived or otherwise extinguished, becomes statute barred, transferred to a related entity or exchanged for shares under the commercial debt forgiveness rules (Div. 245 ITAA 1997).
Writing off the debt by the creditor is insufficient (TR 92/18 and TR 2001/9). A bilateral agreement between the debtor and creditor or a unilateral deed by the creditor notified to the debtor is required (TR 96/23).
The debt forgiveness provision refers to ‘debt’ and not ‘loan’ so does not apply to an extended definition loan UPEs. Accordingly, unlike a loan, a UPE cannot be forgiven by the operation of the statute of limitations.
Statute of limitation loan forgiveness
A loan that has not otherwise constituted a deemed dividend may become a deemed dividend in the income year the 6 year limitation period expires or the private company alters its intention to not require or enforce repayment (sec. 109F ITAA 1936).
An at-call loan is statute barred 6 years after the advance, unless a demand for payment is a pre condition to the cause of action arising for the purposes of the statute of limitations (Ogilvie v Adams [1981] VR 1041; VL Finance P/L v Legudi [2003] VSC 57).
In all Australian jurisdictions other than NSW, after the limitation period expires, the legislation operates ‘to bar the remedy rather than the right’. The debt remains owing, but the legislation limits the enforcement options available to the creditor. If court proceedings are commenced, to recover a statute-barred debt, the debtor can file a defence pleading the expiry of the limitation period, which will be a complete defence to the claim and prevent judgment being entered (ASIC Report 55: Collecting statute-barred debts (September 2005)).
Accordingly, an acknowledgement or part payment of a debt binds the acknowledger or payer and, if made before expiry of the limitation period, binds any successor, but in no circumstances does it bind any other person (sec. 26 LAAV 1958). An acknowledgment or part payment after the expiry of the 6 year limitation period will reinstate the debt and recommence the limitation period (Stage Club Ltd v Millers Hotels P/L [1981] HCA 71).
Broadly:
- the annual return and accounts of a company are an acknowledgment by the company of the debt
- the annual return and accounts of a company are not an acknowledgement by the directors of a debt owed to the company
- the annual return and accounts of an individual trustee are an acknowledgement by the trustee of a debt to the trust or is a breach of trustee duty not subject to a limitation period (VL Finance P/L v Legudi [2003] VSC 57; Di Lorenzo Ceramics P/L v FCT [2007] FCA 1006; Breakwell v FCT [2015] FCA 1471; [2015] AATA 628)
Some pre-1997 loans and some post-1997 loans may have been statute barred and may be forgiven if outside the 4 year amendment period.
Pre-1997 loan Div. 7A forgiveness
The BOT Report indicates that pre-1997 loans will become a Rule of 78 loan from 1 July 2018. Accordingly, it may be appropriate to investigate whether these pre-1997 loans have become statute barred and should be written off before 1 July 2018.
From 4 December 1997, Div. 7A was enacted because the former shareholder loan provision (sec. 108 ITAA 1936) was considered deficient since the provisions were not self-executing, did not apply to unrealised profits and were easily circumvented (IT 2637). In particular, any evidence of an intention to repay the loan (even at an indeterminate date) precluded the provision from applying (DCT v Black [1990] FCA 267).
The forgiveness of a loan constituted a deemed divided under the former shareholder loan provision (Lonsdale Sand & Metal P/L v FCT [1998] FCA 155).
The debt forgiveness rules were relevant for pre-4 December 1997 quarantined loans which would have become forgiven under the statute of limitations by no later than 4 December 2003.
On 15 February 2006, the Commissioner stated that no Div. 7A compliance action would be undertaken on any pre-4 December 1997 loan by a private company or by a trust with a private company beneficiary that may have already become barred under the statute of limitations recognising that these loans were likely statute barred and the Commissioner’s amendment period had expired. Importantly, the Commissioner acknowledges that in writing off of the statute barred amounts, no further taxation consequences arise (PSLA 2006/2).
Accordingly, the pre-1997 loans could be written off without further tax consequence.
However, this was not often undertaken to maintain the solvency of the entities and because it was impractical to establish that there had not been an acknowledgement of the debt recommencing the limitation period so the statute of limitation period had not in fact expired.
Care is required to ensure that the 6 year limitation period has expired and has not been renewed by an acknowledgement or repayment.
Pre-1997 loan Div. 245 forgiveness
The commercial debt forgiveness (Div. 245 ITAA 1997) rules have limited residual application and will not operate to reduce a debtor’s reducible tax attributes where the debtor is solvent.
Div. 7A and Div. 245 may operate concurrently, but where Div. 7A includes an amount in assessable income, the amount is taxable under Div. 7A in priority to the debt forgiveness rules (sec. 109F ITAA 1936; sec. 245-40(b) ITAA 1997).
Accordingly, the commercial debt forgiveness rules will have a residual operation if an amount is not included in assessable income under Div. 7A (eg, where there is a forgiveness of a loan, Div. 7A may not include an amount in assessable income because there is no distributable surplus (sec. 109Y ITAA 1936)). In this circumstance, provided the debtor is solvent, there should be no net forgiven amount to reduce tax balances under the commercial debt forgiveness rules.
Where a debtor’s obligation under a commercial debt (FCT v Tasman Group Services P/L [2009] FCAFC 148) is forgiven (or deemed forgiven), unless exempt, the net forgiven amount will reduce the following tax balances (sec. 245-40 ITAA 1997):
1. the debtor’s deductible revenue losses (sec. 245-110 ITAA 1997); then
2. the debtor’s deductible net carried forward capital losses (sec. 245-125 ITAA 1997); then
3. the debtor’s deductible expenditure, such as expenditure on depreciable plant, scientific research, intellectual property and capital works (sec. 245-140 ITAA 1997); then
4. the debtor’s reducible assets cost bases (sec. 245-165 ITAA 1997).
A solvent debtor is deemed to have given consideration equal to the arm’s length market value of the forgiven debt, so no net forgiven amount arises that would reduce the tax balances (sec. 245-60 ITAA 1997). Any net forgiven amount not applied to reduce the tax balances stated above is extinguished without further tax consequences for the debtor (sec. 245-195 ITAA 1997).
Where the debtor was solvent when the commercial loan is made and forgiven, the creditor does not make a capital loss (sec. 108-5(2), sec. 108-20 & sec 104-25 ITAA 1997 (CGT Event C2) PBR 1011797075763) and the debtor’s tax balances are not reduced under the commercial debt forgiveness rules.
Where the debtor was solvent when the commercial loan is made and insolvent when forgiven, the creditor makes a capital loss (sec. 116-30(3A) ITAA 1997; TD 2; PRB 66871) and the debtor’s tax balance may be reduced under the commercial debt forgiveness rules.
Where the debtor was insolvent or unable to repay the commercial loan when made (sec. 112-20 ITAA 1997; PBR 1011637913960) the creditor does not make a capital loss and the debtor’s tax balances are not reduced under the commercial debt forgiveness rules.
Will or love care an affection loan forgiveness is not exempt from Div. 7A
A forgiveness is exempt under Div. 245 ITAA 1997 when arising under a Will or between individuals for love care and affection (sec. 2405-40 ITAA 1997). A company can forgive a debt for the directors love care and affection of the individual debtor (ATO ID 2003/589 and ATO ID 2003/590; PBR 1012544985991).
There is no exemption under sec. 109G ITAA 1936 for a forgiveness under a Will or for love care and affection. The Will and love care and affection exclusion in Div. 245 ITAA 1997 does not prevent the amount from being a forgiveness under sec. 109F ITAA 1997.
A forgiveness under a Will or for love care and affection is still a debt forgiveness within the definition in sec. 245-35 ITAA 1997. Sec. 245-40 ITAA 1997 operates to exclude such a debt forgiveness from the operation of subdivision 245-C to 245-G ITAA 1997.
Sec. 109F ITAA 1936 refers to an amount being forgiven under sec. 245-35 ITAA 1997 assuming the amount were a debt to which subdivisions 245-C to 245-G ITAA 1997 applied. The effect of this exclusion is to ignore the operation of sec. 245-40 ITAA 1997 for Div. 7A purposes.
Accordingly, a forgiveness under a Will or for love care and affection will not prevent the amount from being assessable under sec. 109F ITAA 1936. If the amount is not otherwise assessable under sec. 109F ITAA 1936, then it could be written off without tax consequences.
Pre-2009 UPE release
If one accepts that UPEs are not ordinary loans or debts (Tindon P/L v Adams [2006] VSC 172; cf Chianti P/L v Leume P/L [2007] WASCA 270; Gustode P/L v Ashley [2011] FCA 250) then the statute of limitation period does not apply and the UPEs are perpetual until formally released. There will be limited opportunity to release these amounts without adverse tax consequences.
A private company is taken to pay a dividend at the end of the current year if a payment is made to a current shareholder (or a shareholder’s associate) or a past shareholder (or a past shareholder’s associate) where a reasonable person would conclude that the payment occurred because of the shareholder or shareholder’s associate relationship (sec. 109C ITAA 1936).
A release of a UPE by a private company is a payment to the extent that the release represents a financial benefit to the trust (being an associate of a shareholder). Where the trust cannot satisfy the UPE, the UPE is valueless and the private company beneficiary may release the UPE without paying a deemed dividend. The UPE may have value if, for example, the trustee breached the trust deed which resulted in the trust being unable to satisfy the UPE (TD 2015/20).
Care is required in quarantining and releasing pre-2009 UPEs to ensure that they do not constitute a reimbursement agreement (sec. 100A ITAA 1936).
Sec. 100A ITAA 1936 is an anti-avoidance provision that cancels the taxation of a beneficiary on certain trust distributions that are effectively diverted to a third party and then taxes the trustee on the trust distributions at the 46.5% rate. Sec. 100A ITAA 1936 deems a beneficiary otherwise presently entitled by operation of the trust deed or by tax law (sec. 101 ITAA 1936) not to be so presently entitled.
Div. 6 ITAA 1936 taxation of trusts applies in the normal manner so that since there is no presently entitled beneficiary the trustee is taxed under sec. 99A ITAA 1936.
A ‘reimbursement agreement’ is defined broadly to include any formal or informal, expressed or implied or enforceable or unenforceable agreement, arrangement or understanding whenever entered into, but does not include such entered into in the course of ordinary family or commercial dealings (sec. 100A(13) ITAA 1936).
A reimbursement agreement may provide for the payment of money, including by way of a loan or by release, failure to demand or to postpone payment of a debt to or for a person other than the beneficiary or for a group of person including the beneficiary.
The scope of what constitutes ordinary family or commercial dealings is likely to be contentious (consider Newton v FCT (1958) 98 CLR 1, Peacock v FCT (1976) 6 ATR 677; Jones v FCT (1977) 7 ATR 229 in the context of sec. 260 ITAA 1936).
Arguably, the exemption should apply where the payment does not exit control of and availability for the same economic unit. For example, husband and wife are an economic unit so movement of income between them is explicable by family dealings (Peacock v FCT (1976) 6 ATR 677; Jones v FCT (1977) 7 ATR 229). Where the third party is not of the same economic unit it is more likely that the arrangement will not be explicable by ordinary family or commercial dealings (Raftland P/L v FCT (2007) 65 ATR 336).
Accordingly, the release of a UPE by a private company beneficiary in a closely held family group is likely to constitute excluded ordinary family or commercial dealings.
On 3 July 2014, the Commissioner issued a facts sheet on the interaction of sec. 100A ITAA 1936 and Div. 7A. In summary, the fact sheet states:
- The Commissioner would generally not apply sec. 100A to a UPE to a private company beneficiary retained by the trust as working capital under a Div. 7A complying loan or complying investment agreement.
- The Commissioner does not have an active compliance program to apply sec. 100A to a pre-2009 UPE to a private company beneficiary retained by the trust as working capital.
- The Commissioner will apply Div. 7A to a pre-2009 UPE to a private company beneficiary in accordance with TR 2010/3 and PSLA 2010/4 and will not actively consider the prior potential application of sec. 100A.
However, it is unclear whether the Commissioner would apply sec. 100A ITAA 1936 if Div. 7A and Div. 245 did not impose taxation on a released UPE
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