On 18 July 2018, the ATO issued Taxation Determination TD 2018/13, which considers whether a Div 7A interposed entity rule (s109T of the ITAA36) can apply to an ordinary commercial payment, or loan from a private company to an interposed entity.
The Commissioner concludes that it can apply, which is to say that a two step transaction, that starts off defensibly, can end up in a deemed dividend (which is, broadly, a bad result – double tax in both the company’s and the shareholder’s hands with no franking credits). He uses 7 examples and concludes that s109T is triggered, in all of the examples, though, in the last 2, other factors reduced the deemed dividend to $nil.
I will take you through the examples, from which will illustrate what the Commissioner is saying, but just as interesting, is that the Commissioner is ‘channelling his inner tax avoider’ by giving 7 examples of how to avoid tax.
Division 7A background
But before taking you through the examples, I will first explain the broad operation of Division 7A of Part III of the ITAA36 (Div 7A) and the operation of the interposed entity rule in s109T.
- A company with profits, could pay them to shareholders as a dividend, which would have tax consequences, even if they were franked (‘top up tax’ for instance). If the company were to loan those profits to a shareholder, there would be no tax consequences, if there were not an ‘anti-avoidance’ provision, in this case, Div 7A.
- Div 7A operates to deem loans, to shareholders of private companies (or their associates), to be assessable dividends (under s109D), and such a deemed dividend, is not frankable (under s202-45(g)(i) ITAA97). Loans that are on so called ‘commercial’ interest and repayment terms, are not deemed to be dividends (under s109N). Neither is this deeming is open ended. Section 109Y limits the deemed amount to the private company’s ‘distributable surplus’.
- There are similar deeming provisions for ‘payments’ to shareholders, of private companies, or their ‘associates’ (under s109C). Because ‘payments’ could be for many things, there are a range of exemptions, including: payments discharging pecuniary obligations (s109J) and payments that would be assessable, anyway, without having to be deemed a dividend (s109N).
- And s109T was inserted, to prevent this regime being defeated by a chain of transactions, no part of which was caught by Div 7A, but the end point was that a shareholder (or associate) of the initiating private company, received a payment or loan. Section 109T will be triggered, if funds flowed from the company, through one or more ‘interposed entities’, to the ‘target’ shareholder (or associate) and “a reasonable person would conclude” that this chain of transactions was “part of an arrangement” to make the payment or loan to the target shareholder or associate. If triggered, then s109V will allow the Commissioner to determine how much of the ultimate payment (to the shareholder or associate) will be deemed to have been paid by the originating private company (and thus open being deemed a dividend under the other provisions of Div 7A. Section 109W has the same effect for loans. The Commissioner can reduce the amount, to which Div 7A is to apply, by the amount that the payment or loan is ‘consideration … for anything’.
The 7 EXAMPLES (and what they show)
I will briefly take you through each of the 7 examples, to see how reasonable the Commissioner’s conclusions are (and you’ll see the ‘tax tricks’ he parades in these examples).
- EXAMPLE 1 – involves a private company paying a fully franked dividend, to one of its shareholders: a company (which is the ‘commercial’ transaction). The shareholder company then lends the same amount, on the same day, without interest, to an individual, who is the other shareholder in the originating private company. These ‘same day, same amount’ circumstances help brand it as an ‘arrangement’ to get the interest free loan to the individual, who would have received a deemed dividend, had the loan been made directly by the initiating private company. But this arrangement, is also made possible by there being no tax to pay on the path through the interposed corporate shareholder. This was provided by the normal operation of the franking system, which results in one company having no tax to pay, when receiving another company’s franked dividend.
- EXAMPLE 2 – is the same as above, except the sole shareholder (the interposed entity) is a Family Trust, which makes a loan to the sole director of the initiating company (who is an ‘associate’ of the sole shareholder Trust). The Family Trust uses the franked dividend amount to make an interest free loan to the sole director, who doesn’t repay the loan. Again, the dividend amount is loaned on the same day as it is received. This would probably be enough to brand this as part of an ‘arrangement’ to get the ultimate loan amount to the director. However, there is a slightly different ‘tax avoidance’ aspect, which also adds weight to this conclusion. In Example 1, the corporate shareholder would have no tax to pay, because the dividend was franked. In this example, the tax is on the beneficiary (not the Trust). However, there will be no tax to pay as beneficiary is a non-resident. Because the non-resident is ‘presently entitled’ to the Trust’s dividend income (s128A(3)) the dividend withholding tax provisions apply. No withholding required, however, as the dividend was franked (s128B(3)(ga)(i)). And despite there being no withholding tax to pay, the fact that it was a ‘franked dividend’ means there is no other tax to pay, either (s128D). There was no need, therefore, for the Trust to pay the dividend amount, to the non-resident, to get a nil tax result (creating the ‘present entitlement’ alone, was enough). As a result, there was no economic imperative, on the director, to repay the loan. This intricacy would also contribute to the conclusion that this was all an ‘arrangement’ to get the loan to the director.
- EXAMPLE 3 – again involves an interest free loan to the sole director of the initiating private company (that director, being an ‘associate’ of the sole shareholder Family Trust). The initiating company subscribes for units in a related trust, which proceeds to make an interest free loan, of the same amount, to the sole director, who doesn’t repay the loan. Again, the circle of funds, in the same amount and on the same day would probably have been enough to brand this as part of the same arrangement, but again the capacity to make this amount go around, without tax is important and this time it is done by making the initial payment a subscription for capital.
- EXAMPLE 4 – again involves similar facts, except there shareholder associate (the company’s sole director) gets a house, not a loan, and this is deemed to be a ‘payment’, for Div 7A purposes (from the initiating private company, to the director/shareholder ‘associate’). The trail of funds is as follows. The initiating private company pays a $1m franked dividend to the sole shareholder Family Trust, which uses most of it ($950k) to buy a residential property. Within the same year it distributes property, in specie, to the sole director. Here the amounts are not identical and there is a time gap (albeit still in the same year), making it less of a ‘slam dunk’, that the dividend is an ‘arrangement’, to get the house into the director’s hands. But there’s another ‘tax trick’ to avoid tax interfering with the flow of funds, that will ‘nail’ this as a relevant ‘arrangement’. This time, the trustee says that the ‘trust law’ income is the $1m dividend, less the $950k amount, which was lost, in making the in-specie distribution (relying on a clause in the deed that said this). The Trustee then distributes the remaining $50k, of ‘trust law’ income, to a corporate beneficiary. The $50k of actual income sucks, with it, the $1m of assessable dividend income, and the $428k of assessable franking gross-up. The full franking credit would, also pass through the trust, to the corporate beneficiary, leaving it with no tax to pay after receiving only a small portion of the assessable $1m dividend. Furthermore, the original $428k franking credit remains in tact, to be distributed with any tax free profits the company might have, or earn in the future.
- EXAMPLE 5 – uses the same ‘trick’ to avoid tax, on the funds flow, but the chain of transactions are spread across 2 years, and are much more diffuse, so you need this ‘trick’, to link them all together, as potentially a relevant ‘arrangement’. The trail of transactions are these. The initiating private company is pregnant with accumulated profits and the shareholder Family Trust revalues its shares, up, to reflect their net worth. It then uses this asset revaluation reserve to distribute an amount of capital, out of the trust (which is not paid at that point). The following year, the company does pay a $1m franked dividend, to the Trust, which depletes the value of the shares, causing a loss, which the trust deed says must be set off against income, before striking the trust’s distributable income. This leaves only a small amount of income, that is distributable, which the Trust did distribute, to a corporate beneficiary (which has no tax to pay because it receives the franking credit, which offsets it very large tax liability). This left the $1m dividend amount, not taxable, and available to fund the tax free capital distribution, from the previous year.
- EXAMPLE 6 – involves a private company paying a franked dividend, to its sole shareholder: a Family Trust. These entities are related in that the sole director of the company: Mr Z is also the trustee of the Family Trust and also one of its beneficiaries. His wife: Mrs Z is also a beneficiary and it was to her that the Trust distributed its franked dividend income. Rather than receive it, herself, she directed the trustee to pay her money to her husband (but, of course, she was still taxed on the trust distribution, as it was dealt with as she directed – deemed derivation). In short, there was no ‘tax trick’ her to make the moneys tax free and full tax was paid. Here the Commissioner’s analysis is ‘interesting’. He says that a reasonable person would regard this as an ‘arrangement’ by which the dividend was paid, to get it to Mr T – but that is hard to see, as it would not be evident that Mrs would chose to give her trust entitlement to her husband, whilst being taxed on it herself. In any event, the Commissioner goes on to say that the deemed payment to Mr Z, would be reduced to $nil, under s109V. However, a reduction under this section, is only available for an amount that “the Commissioner believes represented consideration payable to the target entity, by the private company, or any of the interposed entities, for anything”. The Commissioner explained (in para 6 of his Determination) that this reduction was applicable because tax was paid and the money stayed within the family. It seems that if tax is paid, then the Commissioner is prepared to concede that a payment, satisfying a trust entitlement, is ‘consideration’ for extinguishing that entitlement. I would have thought that was the case, irrespective of whether tax is paid.
- EXAMPLE 7 – is the loan equivalent of Example 6. The same private company makes the same franked dividend payment to a related Family Trust, which is its sole shareholder. The Trust loans the dividend amount, interest free, to one of its beneficiaries (Mr X, an ‘associate’ of the Trustee shareholder). Mr X does not repay this loan. By year end, the Trust distributes its dividend income, to a corporate beneficiary (another company). The Corporate Beneficiary has no tax to pay, on the fully franked dividend, that passed through the Family Trust, because its tax is no more than the franking credit, that passed through the Trust too. I due course, the Corporate Beneficiary turned its unpaid present entitlement, to this dividend income, into a loan to the Trustee, on interest and repayment terms that were ‘commercial’ under s109N (to prevent the unpaid present entitlement being a Div 7A deemed dividend to the Trustee (as it’s shareholder). Somewhere, out of this scramble of things, the Commissioner is prepared to recognise that Div 7A compliance in one place reduces Div 7A avoidance in another place – because, somehow, the interest free loan was ‘consideration’ for something (quite what, I don’t know, unless it is consideration for the promise to repay it – in which case, that ought to apply always).
DATE OF EFFECT: TD 2018/13 applies before and after its date of issue. It finalises draft TD 2017/D3 and contains the same views as the draft.
Comprehension questions (answers available)
- Does Div 7A deem certain loans and payments, to shareholders of private companies (and associates of those shareholders) to be dividends, that are generally unfranked?
- Is this to force private companies to either keep their retained profits or get their shareholders to pay tax on those profits as distributed dividends?
- Does s109T look at the cumulative effect of benefits given to shareholders (or their associates) through interposed entities?
- Does s109T apply if the transactions, through the interposed entities, appear to be an ‘arrangement’ to get the ultimate payment or loan to the originating private company’s shareholders (or their ‘associates’).
- Does s109T deem the amount, which the last interposed entity pays or lends to the ‘target’ shareholder (or associate), to have been paid or lent by the originating private company?
- Does the Commissioner give 7 examples of how s109T applies?
- Does he find that s109T applies in all of them?
- Does he find that Div 7A applies in all of them?
- Does it matter whether no tax is paid overall?