It all began when Fred saw you about buying the farm next door. His existing farm was held by a family company set up years ago. Fred wanted to buy the new farm in the family company to keep things together. You wisely said you should speak to Fred’s accountant, Roger, first.
First near miss
Roger said it would be better for Fred to buy the new farm in his own name. When he sells to retire, at least under current law, he would pay tax on half the capital gain only - thanks to the 50 per cent discount on capital gains. However, if he buys it in the company name and later sells, the company will pay 30 per cent tax on the full capital gain and the distribution on winding up will be taxed as a dividend with no discount for the capital gain. So, twice the tax.
Second near miss
Fred had to borrow $500,000 to buy the new farm and his Bank required a guarantee mortgage from the family company, in addition to a mortgage from Fred over the new farm being purchased.
Roger warned you to make sure that under the guarantee mortgage documents the family company’s liability was contingent and would only arise if Fred defaulted under the mortgage of the new farm. Roger explained that if the family company’s liability was not contingent, the loan would be treated as an unfranked dividend to Fred. Roger said this was one of the problems created by Division 7A of the Income Tax Assessment Act 1936.
Under s 109C of that Act, a payment by private company to a shareholder or associate is treated as an unfranked dividend. Under other sections, mainly s 109UA, a bank loan secured by a private company guarantee is deemed a dividend if the loan is to a shareholder or associate unless the liability is only contingent.
When the documents arrived from the Bank you saw a clause stating the family company and Fred would be jointly and severally liable for payment of the debt. There was some hassle with the Bank but you fixed it. The Bank’s lawyers drew up a deed by which the Bank limited its right to make a claim against the Company unless Fred defaulted.
Fred was impressed with the work done by you and Roger. You agreed with his interpretation that when he finally sold the new farm he would only pay tax on half the capital gain and that, by fixing the wording on the guarantee, he didn’t have to worry about tax on the $500,000.
But unfortunately – the final sting
A year or so later Fred consulted you about a letter he received from the Bank. Fred was hard hit by the drought and couldn’t maintain payments. The Bank was demanding payment from the family company under the guarantee.
Before speaking to Roger you did some research and saw to your horror the example in s 109UA indicating that when a borrower defaults, the guarantor company is to pay a deemed dividend to the borrower – Fred – of the amount payable.
You rapidly organised a meeting with Roger to discuss, and this is what you found.
Section 109RB allows the Commissioner to disregard a Division 7A dividend but only on the specific grounds of ‘honest mistake or inadvertent omission’ by anyone relevant to the situation. No help there.
The ATO has a website offering help to drought affected farmers but all this offers is time to pay.
Section 340-5 of schedule 1 to the Taxation Administration Act 1953 allows the Commissioner to release an individual from payment of tax if ‘you would suffer serious hardship if you were required to satisfy the liability’.
That’s all very well but in PS LA 2011/7 the ATO states that ‘[w]e consider serious hardship to exist where the payment of a tax liability would result in a person being left without the means to afford basics such as food, clothing, medical supplies, accommodation, or education.’ This makes it hard for poor Fred, because even after selling the farm to pay the debt and the tax on the amount of that debt he would still have several million dollars left over.
Very gloomy discussions followed between yourself and Roger. Whatever could you tell Fred?
Take away points
- Initial choice of entity has long-term consequences.
- Division 7A of the Income Tax Assessment Act 1936 is complex and severe.
- Liaising with a client’s accountant is always good practice.
This article is published in this month’s edition of the Law Society Journal of NSW.