The Tribunal’s warning on Division 7A loans

One way to prevent the full loan balance from being treated as a deemed dividend in the year it is made is to ensure the loan is placed under a complying Division 7A loan agreement by the earlier of the due date and actual lodgment date of the company’s tax return for that year. Keep in mind that minimum annual repayments are normally still required in future years to prevent deemed dividends from being triggered.

To be considered a complying loan agreement, section 109N ITAA 1936 requires – amongst other things - that the agreement that the loan was made under is in writing. In TD 2008/8 the ATO explains the entire agreement between the parties must be in writing. This includes the names of the parties, loan amount and terms, the parties’ agreement to the terms and when the agreement was made.

One of the issues in the Botella case was whether the pro-forma loan agreement set out in the company’s constitution was – by itself - enough to meet the requirement in section 109N. While the company’s constitution stated that every loan made by the company to a shareholder is deemed to have been made in accordance with the terms of a loan agreement set out in its schedule, the Tribunal concluded that this was not sufficient for the purposes of section 109N.

The Tribunal considered that the deeming clauses operated after the funds were lent. As such, the loan was made through the conduct of the advances taking place during the year, rather than through the deeming clauses. In any case, the Tribunal considered that the constitution itself did not record an agreement between the company and the member.

This is consistent with the ATO’s position in TD 2008/8. While a company might have pro-forma loan clauses in its constitution, the ATO suggests that a separate agreement in writing between the company and the borrower would still be necessary. Example 4 indicates that this can include a separate agreement between the borrower and company stipulating that the loan would be governed by those loan terms set out in the constitution.

Aside from pro-form loan clauses in a company constitution, in practice it is relatively common to see the parties enter into a facility agreement that covers multiple loans made during an income year. TD 2008/8 suggests this can be effective if appropriate wording is used and supporting evidence is available. The ATO guide ‘Loans by private companies’ also indicates that a written agreement can be drafted to cover loans which will be made to someone for a number of income years in the future.

However, this doesn’t help if you discover a situation involving an older loan where no complying Division 7A loan agreement was put in place by the relevant deadline. The approach will depend on the situation.

First, you might find that the amount of the deemed dividend is nil or a nominal amount because of the ‘distributable surplus’ rules. If the company’s distributable surplus (calculated under section 109Y) was nil at the end of the year in which the loan was made, then then taxable deemed dividend amount should be nil under Division 7A.

In appropriate cases it might be worth seeking the Commissioner’s discretion to disregard the deemed dividend or allow it to be franked on the basis that the issue arose due to a honest mistake or inadvertent error. PS LA 2011/29 sets out guidance on this process.

If an assessable deemed dividend has been triggered in a prior year then you would normally need to consider whether the amendment period for that year has expired. If not, then it is worth exploring whether the borrower might have some tax losses that can be offset against the assessable deemed dividend.

What is clear is that the Division 7A rules have the potential to trigger some significant adverse tax issues. The Botella case is a reminder to not neglect documentation and make sure that Division 7A loan agreements are in place and adequate.

Matthew Tse is a tax adviser at Knowledge Shop.