Your farming clients Paul and Mary have suffered an extended drought and are unable to meet their latest bank interest payment. They have come to you for advice. Their trading entity (which owes the money) is a discretionary trust with a corporate trustee of which Paul and Mary are the shareholders and directors. Paul and Mary and their family are all potential beneficiaries of the trust. The bank has a mortgage over the farm, partly owned by an old family company (in which Paul is the shareholder) and partly by Paul and Mary personally.
You are aware of the peril of division 7A of the Income Tax Assessment Act 1936 (“ITAA 1936”) where third-party debts are guaranteed by companies.
When they signed the mortgage, you explained to Paul and Mary that where a company guarantees a debt owed by a shareholder or associate, unless the liability is contingent only, the amount of the loan is (subject to a few conditions) deemed to be a dividend (s 109UA).
So the bank documents, which at first imposed joint liability on both the company and the trust, were amended to make the company liable only in the event of a default by the trust.
Now there is a new problem. If Paul and Mary fail to make the interest payment, the company will become directly liable for the debt - and the deeming provision in s 109UA is likely to apply.
You advise Paul and Mary accordingly, who obtain an extension from their bank provided part of the farm will be sold to reduce the debt.
Paul and Mary duly negotiate a sale by the family company on which you act. On settlement, the bank hands over a discharge of mortgage in exchange for the debt reduction.
Some months later you receive an irate telephone call from Paul and Mary’s accountant, Peter. He asks why on earth you didn’t advise Paul and Mary to sell the land in their names.
By selling company land, you have created a tax nightmare.
Somewhat offended, you go on the defensive and point out the steps taken by you to avoid the problems of division 7A, not only when the loan was first taken out but also when default loomed.
“But what about the payment?” Peter asks. “Well,” you respond, “it had to go to the bank - the bank had the mortgage.” But Peter says, “the debt didn’t belong to the company - it belonged to the trust. So it was, in effect, a payment to the trust.”
Realising you are getting into dangerous territory, you tell Peter you have an urgent appointment and will get back to him when you are free.
You immediately call your accountant, Tilla, for advice. Tilla explains that under section 109C(1)(a) of ITAA 1936 a payment to a shareholder or associate is, subject to some conditions, deemed to be an unfrankable dividend
Further, under sub-s (3)(a) ‘payment’ includes payments ‘on behalf of the entity or for the benefit of the entity’
“Okay,” you say, “Paul owns the shares in the landowning company, but is the family trust really his ‘associate’?”
“Unfortunately yes,” Tilla responds, “by a combination of ss 109ZD and 318(1)(d) this is so”.
So what happens next?
“Well,” Tilla says, “provided Paul and Mary’s accountant hasn’t done the tax return yet, and the required lodgement date hasn’t passed, under s 109D(4A) the payment can be converted to a loan.” “Great,” you say. “You mean one of those book debts that never gets paid?”
Unfortunately not. To avoid the debt repayment being deemed a dividend the ‘loan’ must be repaid to the family company within seven years if unsecured or 25 years if secured. And interest at a set rate - currently 5.95 per cent but which varies – must be paid every year.
And it can’t be for 25 years because s 109N requires that initially the market value of the security, less any prior mortgages, must be at least 110 per cent of the loan.
And you know this won’t work because the mortgage has to be over Paul and Mary’s land, and the equity isn’t there
“So the best Paul and Mary can do,” Tilla says, “is have the trust sign an unsecured seven-year loan.” At least this keeps the debt from becoming taxable in year one.
But the company will be taxed on the interest. And the payments will be locked up in the company unless the money is invested or paid to Paul (as sole shareholder of the landowning company) as assessable dividends.”
“If only,” Tilla says, “Paul and Mary had sold their own land this problem would not have arisen.”
• A third-party loan guaranteed by a private company can be deemed an unfranked dividend to the borrower under division 7A of the Income Tax Assessment Act 1936 unless the liability is contingent.
• Division 7A can deem a third-party loan an unfranked dividend if the third party defaults.
• Repayment by private company of a third-party debt can be deemed a dividend under division 7A.
This article is general information only and should not be relied on without obtaining further specific information.
Author: Jim Main