Publications and News

Risks of company guarantees

3 September 2013

Farming clients Charlotte and George have had a terrible year with persistent rain during the harvest period resulting in a complete crop failure. Because of the crop failure, they were unable to meet their latest interest payment to the bank.
Charlotte and George trade as a partnership and all of their bank borrowings of $1,000,000 are in their personal names.

The farming land on which they conduct their business is owned by their family company. Charlotte and George own all the shares in the company and the company has no debts.

When Charlotte and George refinanced their borrowings a few years ago the bank asked that the company act as a guarantor for the partnership debts and that the guarantee be supported by a mortgage over the farm.

Prior to advising the company on signing the guarantee you, with Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) in mind, you reviewed the document only to find that the liability was not contingent on a default by Charlotte and George. You knew that if the company signed the guarantee as it was, the loan amount would have been a deemed dividend to Charlotte and George when the guarantee was entered into.

To avoid this problem, you asked the bank to amend the guarantee so the liability of the company was contingent on a default by Charlotte and George.

The bank agreed to and made the amendment to the guarantee, the documents were signed and the refinance was completed.

The future at the time looked good and you did not think about what would happen if the contingency occurred and the company became directly liable for the debt.

The sting

Although the company liability was contingent on the default when the guarantee was entered into, as soon as Charlotte and George missed their interest payment they were in dafault, under the terms of their loan agreement, and the company guarantee became “other than contingent”.

As the company has a distributable surplus (broadly, the company’s net assets less paid up capital) the loan of $1,000,000 became a deemed dividend to Charlotte and George as soon as they were in default.

So, in addition to missing their interest payment, Charlotte and George may now have to pay tax on the $1,000,000 loan, assuming their farming losses are not big enough to offset the dividend.

Section 109UA (3) ITAA 1936 gives the Commissioner a discretion not to treat the loan amount as a dividend if the Commissioner is satisfied that:

1. Charlotte and George would suffer undue hardship because of the dividend; and
2. when Charlotte and George entered into the loan with their bank they had the capacity to pay the loan.

The explanatory memorandum to the Bill adding section 109UA(3) states that the Commissioners discretion could be exercised “in circumstances where a shareholder (or associate) is financially unable to meet the payments through no fault of their own: for example, where a shareholder has been involuntarily retrenched from his or her employment”.

The explanatory Memorandum also provides the following example:

“A private company guarantees a loan that a bank makes to a shareholder in the private company and that shareholder technically defaults under the loan agreement by failing to make a repayment by the due date. The shareholder makes the necessary repayment to the bank shortly after the due date, out of the shareholder's own funds. The bank does not call upon the company to meet its obligation under the guarantee and no payment is actually made by the company (or any of its associates) to the bank in respect of that guarantee.”

Whether or not a failed crop would make the Commissioner exercise his discretion is unknown. However, if, Charlotte and George are unlikely to be able to make the payment in the near future the facts in the example could not be followed.
Section 109UA (3) only applies to guarantees given after 27 March 1998.

To avoid the problem, Charlotte and George should have gone to their bank before they missed the interest payment and attempted to make arrangements - for example, by increasing their borrowing limit, to ensure they were not in default when they could not meet their interest payment. 

Author: Amanda Tully

This article is general information only and should not be relied on without obtaining further specific information.

 

Amanda Tully Business Lawyer / Director

Amanda Tully is a business lawyer whom acts for clients on a wide range of business succession and other commercial matters. Amanda’s experi.. Learn more about Amanda Tully

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