Division 7A loan agreements: Proposed Reforms and Recent Cases

The government and the ATO are increasingly vigilant in relation to Division 7A tax planning. Some recent cases exposed an avoidance scheme involving "promissory notes" and rendered it ineffective. The Government has proposed reforms to make the Division 7A exceptions fairer and to prevent their abuse.

What does Division 7A do?

Division 7A of the Income Tax Assessment Act 1936 (Div 7A) aims to make sure shareholders pay income tax on amounts they receive from their companies. It achieves that aim by deeming each of the following payments to be a dividend (on which income tax must be paid):

• most payments (other than salary, wages, bonuses etc.) from a company to a shareholder or a shareholder's associates;
• an undocumented loan from a company to a shareholder or a shareholder's associates;
• a company forgiving a debt owed by a shareholder or a shareholder's associates;
• most payments (other than salary, wages, bonuses etc.) by trusts to individuals who are shareholders (or associates) of companies that are entitled to receive unpaid trust distributions from those trusts.

As a tax integrity measure, Div 7A is generally effective in preventing shareholders from failing to pay tax on receipts from their companies. However:

• there are some legitimate ways to limit the effect of Div 7A — for example through a Division 7A Loan Agreement, discussed under the next heading; and
• from time to time some attempts to circumvent the rules end up in the courts and tribunals — see the cases discussed below.

What is the role of the Div 7A Loan Agreement?

One legal way to avoid a payment being deemed a dividend and assessed for income tax is for the company/trustee and the recipient to enter into a Div 7A Loan Agreement.

What do the recent cases tell us?

Some attempts to circumvent Div 7A are less than subtle, are easily spotted, and are ineffective — as is shown by 4 recent cases¹ , involving identical tax avoidance schemes, which were heard before the Commonwealth Administrative Appeals tribunal.

The facts

Each of the cases involved an elaborate scheme in which:

• a shareholder borrowed amounts from a company on the basis of a promissory note: a document under which the shareholder promised to repay the company;
• the shareholder later arranged for the company to draw a cheque for the amount of the debt payable and provide the cheque to the shareholder on the basis that the shareholder would not bank the cheque
• a shareholder then endorsed the cheque to a finance company, and arranged for the finance company to endorse the cheque back to the company
• the company then received the endorsed cheque in satisfaction of the original debt.

Effectively the shareholder purported to pay the company with a valueless piece of paper which the company had itself issued. The company accepted repayment of the debt in this form.

The taxpayers' argument

In each case, the taxpayer argued that the so called "promissory note" the company issued in relation to a forgiven loan:

• was a written agreement for the purposes of Div 7A; and
• therefore had the effect of a Division 7A Loan Agreement — which meant that the forgiven loan should not be deemed to be a dividend under Div 7A.

The decisions

The AAT held:

• that the so called "promissory notes" were, for the purpose of Div 7A, merely unilateral promises to make payments. Therefore, they did not qualify as contractual agreements; and
• that even if the "promissory note" was more than a unilateral promise, the arrangement was a sham because the company and the shareholder did not intend the that the shareholder would act in accordance with the promise set out in the "promissory note".

What reforms were proposed in the 2009 Budget?

As part of the 2009 Federal Budget announcements in May, the Federal Government announced that it would tighten the non-commercial loan rules in Div 7A. The proposed amendments are in a Treasury Discussion Paper issued on 5 June 2009. A copy of the Discussion Paper can be downloaded here.

The amendments are very technical so we cannot describe them in detail here. The reforms have two primary objectives:

1. Closing down a number of schemes to circumvent the effects of Div 7A, such as through strategically interposed companies or trusts, or carefully timed cross loans.

   For example: Any payment by a trust to a shareholder of a company that is a beneficiary of the trust and that has an unpaid present entitlement to money from the trust is deemed to be a dividend (and so is assessable for income tax). However, the Government is concerned that the relevant rule could be circumvented by the company making the payment as a loan to an unrelated company which then on-loans the money to a beneficiary. The Government proposes amendments to cover this situation.

2. Making Div 7A fairer, including by eliminating double taxation in some circumstances and making sure the rules for loans by trusts are treated the same as private company loans.

   For example: Double taxation can occur if a trustee makes a loan to a shareholder of a beneficiary company and that loan is later forgiven. First the loan is deemed to be a dividend², and so is assessed for income tax. Later, the forgiving of repayment of the loan is also deemed to be a dividend³, and is taxed again. So the shareholder is taxed twice on the one loan. In contrast, if a company makes a loan to a shareholder, then the forgiving of the loan is not treated as a dividend as long as the loan was originally treated as a dividend. The Government would like to make the rules for companies and trusts consistent.

Comments on the proposals

The closing date for submissions in relation to the Discussion Paper was 3 July 2009. To date there has been no response to submissions made, nor is draft legislation available. However, ClearLaw will continue to monitor the progress of the suggested changes.

Conclusion

The cases and the proposed reforms show that the Government and the Tax Office are vigilant in terms of tax schemes to avoid Div 7A.

It is important for companies, trusts (and their advisers) to make sure they properly document shareholder (and associate) loan arrangements. If a payment is deemed to be a dividend, then it will be assessable for income tax — any later attempt to treat a payment as a loan will fail if there are no supporting documents.

Earlier ClearLaw articles on Division 7A

• May 2008 "Changes to Division 7A and the Tax Commissioner's grace period for past mistakes — Cleardocs provides a solution" (the grace period expired on 30 June 2008)
• March 2008 Division 7A: Some thinking from the ATO on Division 7A implications for "former shareholders and associates"

Any questions?

For more information, please contact Maddocks (03 9288 0555) and ask for a member of the Cleardocs Help Desk. They will put you in contact with the relevant Tax & Revenue lawyer in Melbourne or Sydney.

More Cleardocs information on Division 7A

Read about the Cleardocs Division 7A Loan Agreement

Order a Cleardocs Division 7A Loan Agreement

Download a checklist of the information you need to order Cleardocs Division 7A Loan Agreement

¹Confidential and Commissioner of Taxation [2009] AATA 435, 436, 437 and 438. ²by Subdivision EA of Div7A ³again by Subdivision EA