Unlike previous changes to Division 7A, the proposed changes under TD 2012/10 could actually be advantageous for taxpayers whose transactions fall under Division 7A.
Recap of Division 7A
The Division 7A provisions effectively deem certain amounts paid, lent or forgiven by a private company to its shareholders or their associates to be a dividend. These amounts include, for example, an interest-free loan made to a shareholder by a private company. The provision stops shareholders or their associates from reaching into the company to take funds and property for their own benefit as a tax-free payment.
‘Distributable surplus’ and Division 7A
The value of the deemed dividend (being the amount paid, lent or forgiven by a private company to its shareholders or their associates) is limited to the value of the distributable surplus in the company. That is, the deemed dividend is assessable for the shareholder or their associate only to the extent of the distributable surplus.
The formula for calculating the distributable surplus is set out in s 109 Y(2) of the Income Tax Assessment Act 1936 as:
Distributable surplus
= (Net assets) – (Division 7A amounts) – (non-commercial loans) – (paid-up share value) – (repayments of non-commercial loans)
For example, if during the year ending 2010/11 a company issued an interest-free loan to one of its shareholders for $55,000, and the company’s distributable profit at year end was calculated to be $50,000, the amount of the deemed dividend assessable to the shareholder is limited to $50,000.
The net assets referred to in the formula are the company’s assets less its ‘present legal obligations’. Determining the amount that forms part of a private company’s present legal obligations was at the crux of the recent 2010 Full Federal Court decision in FCT v H 2010 ATC FCAFC 128 (H Case).
As a result of the decision, the Tax Office has changed its view on present legal obligations, hence the new determination.
The H Case
The H Case considered whether income tax payable for an income year should be included as a present legal obligation for the purposes of calculating distributable surplus in the event of a Division 7A application.
The Full Federal Court took the meaning of distributable surplus to be a distribution from the company’s after-tax profit. The court found that the company was under a present legal obligation to pay income tax at the end of a financial year, regardless of the fact that no tax return or notice of assessment was issued by the Commissioner until the following tax year.
Further, the court determined that “the obligation came into existence on 30 June of the income year in respect of which the income was derived”, regardless of the fact that the amount payable could not be enforced by the Commissioner until an assessment was actually issued. This differs from the position previously held by the Commissioner as expressed in TD 2008/28, where he said that no present obligation existed until a notice of assessment had been issued to the taxpayer in the following income year (this does not apply to outstanding PAYG instalments, which are accepted as a present legal obligation as they are legally enforceable).
