In Abichandani v FCT  AATA 4296 (‘Abichandani’s case’), the Administrative Appeals Tribunal (AAT) decided that loans made by a company to its shareholders and the transfer of property to an associated entity gave rise to deemed dividends under Division 7A of the Income Tax Assessment Act 1936.
This case illustrates the danger of using a private company to conduct business activities and fund the private affairs of those that control the company. It is also a great reminder of the significance of preparing all necessary documentation when it comes to dealing with Division 7A, which proved to be a costly oversight for the taxpayers in the Abichandani matter.
In this article, we will briefly outline the provisions of the Division 7A Tax and what to be wary of.
Payment of Dividends to Entities: Shareholder Loans and the Criteria
The Act provides that a private company (including a non-resident company) is taken to pay a dividend to an ‘entity’ if all of the following requirements are satisfied:
a) The private company makes a ‘loan’ to the entity during the income year and the entity is either a shareholder (or associate of a shareholder (‘associate’)) at the time the loan is made, or
b) A reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time).
c) The loan is not fully repaid before the ‘lodgment day’ for the income year. Notably, ‘lodgment day’ is defined as the earlier of the due date of lodgment, and the actual day of lodgment, of the company’s tax return for the income year in which the loan in question was made. It is an important concept that is often used to establish the day by which certain actions must be taken to avoid Division 7A consequences arising (e.g., a loan that is fully repaid by ‘lodgment day’ does not trigger Division 7A).
d) None of the exclusions provided for prevent the private company from being taken to pay a dividend. There are a number of potential exclusions that may apply, however, the most relevant to the topic at hand is the exclusion for commercial loans.
A dividend will not arise in respect of a loan where the loan is made under a complying loan agreement. Among other things, the agreement must be in writing, be entered into by the ‘lodgment day’ and minimum interest and principal repayments must be made in respect of the loan.
If a company is taken to have paid a dividend, then that the amount of the dividend taken to have been paid is the amount of the loan that has not been repaid before the ‘lodgment day’ for the current year. Importantly, this amount is also capped at the level of the company’s distributable surplus as calculated by the Income Tax Assessment Act.
Importantly, the term, ‘loan’ is also defined in the Act and, in addition to its’ ordinary meaning can include an advance of money, a transaction (whatever its terms or form) which substantiate a loan of money and a payment of an amount for, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount.
Payments and Division 7A
Under a section of the Act, a private company is taken to pay a dividend to a shareholder (or their associate) if the company pays the shareholder (or associate) an amount during the income year. For Division 7A purposes, a payment to a shareholder is defined under two sections to mean:
a) A payment to the extent that it is to the shareholder (or associate), on behalf of the shareholder or for the benefit of the shareholder (or associate);
b) A credit of an amount to the extent that it is to the shareholder (or associate), on behalf of the shareholder (or associate) or for the benefit of the shareholder (or associate);
c) A transfer of property to the shareholder (or associate) (note: this includes, among other things, the right to use real property under a lease); and
d) A payment also includes the provision of an asset for use by the shareholder (or associate) – this provision basically extends the concept of a ‘payment’ to also include a licence, or an informal right to use an asset (i.e., to the mere use of an asset).
The dividend is equal to the ‘amount paid’, subject to the company’s distributable surplus. In the context of either the transfer or use of property, this basically means the amount that would have been paid for the transfer of the property, or its use (as appropriate) by parties dealing at arm’s length less any consideration given by the shareholder to the company.
Division 7A and the Commissioner’s Discretion
The Commissioner has a discretion as per a section of the Income Tax Assessment Act, to disregard a deemed dividend, or to allow the deemed dividend to be franked if the dividend arose because of an honest mistake or inadvertent omission. Obtaining relief under the section involves the following two-step process:
Step 1: The threshold question is whether Division 7A is triggered because of either an honest mistake, or an inadvertent omission by the recipient, the private company or any other entity whose conduct contributed to that result.
The terms ‘honest mistake’ and ‘inadvertent omission’ are not defined in the legislation, and therefore, take on their ordinary meaning. The ATO’s guidance provides that for the purposes of the section, a mistake is an incorrect view, opinion or misunderstanding as to how Division 7A operates (and such a mistake must be honestly made). On the other hand, an omission is a failure to take action that is relevant to or affects the operation of Division 7A (and such an omission must be inadvertent).
Step 2: The Commissioner must then consider the following factors to determine whether discretion should be granted and whether any conditions should be imposed:
• The circumstances that led to the mistake or omission;
• The extent to which any of the relevant entities mentioned in Step 1 have taken action to try to correct the mistake or omission and if so, how quickly that action was taken;
• Whether Division 7A has operated previously in relation to any of the relevant entities, and if so, the circumstances in which this occurred; and
• Any other matters that the Commissioner considers relevant.
A mistake, or an omission arising as a result of ignorance can attract relief under the section, provided the state of being ignorant, or the reasons for it, are honest or inadvertent. However, deliberate action to remain ignorant of the requirements of Division 7A (including taking a ‘head in the sand’ approach), where the taxpayer is generally aware of the existence of the provisions, would not constitute an honest mistake or inadvertent omission, leaving that person liable.
For professional advice with regards to shareholder loans, income tax or any other taxation or accounting query, contact the team at Quinn Consultants on 02 9223 9166 or submit an online enquiry.