Where assets are owned by a company, care is required to ensure that any transfer of those assets, including any proposed cash payments, do not trigger a deemed dividend under Division 7A of the Tax Act 1936.
Division 7A sets out the consequences of a private company making payments or lending money to a shareholder or associate of the company.
In broad terms, where a private company with a distributable surplus makes a payment to a shareholder or their associate, section 109C Tax Act 1936 deems the payment to be an unfranked dividend.
A company’s distributable surplus is often equal to its retained earnings, although the specific formula to be applied to determine the distributable surplus is:
Distributable surplus = net assets plus Division 7A amounts less non-commercial loans less paid up share value less repayments of non-commercial loans
Similarly, where a private company lends money to a shareholder or their associate, section 109D Tax Act 1936 deems the amount of the loan to be an unfranked dividend.
Finally, if a private company forgives a debt owed to it by a shareholder or their associate, section 109F Tax Act 1936 deems the forgiven amount to be an unfranked dividend.
It is common for family law consent orders or a binding financial agreement to include directions requiring a private company to either:
- transfer one or more of its assets to an individual spouse; or
- make a cash payment to an individual spouse.
Both transactions potentially give rise to adverse tax ramifications under Division 7A, as the spouse will inevitably be either a shareholder or an associate of a shareholder, at the time the transfer or payment is made.
Section 109J Tax Act 1936 provides that a private company is not taken to have paid a dividend under section 109C where the payment of the amount:
- discharges an obligation of the private company to pay money to the recipient; and
- is for no more than the amount required to discharge the obligation, where the company and the recipient are dealing at arm’s length.
Historically, the Tax Office had taken the view (expressed in private binding ruling 85828) that where a company was ordered to pay an amount to a shareholder or their associate pursuant to a Family Court order, the payment would not trigger a deemed dividend under Division 7A as it was made to discharge a financial obligation imposed on the company by a Court order and was therefore exempt under section 109J.
In 2014 however, the Tax Office revised their position and issued Taxation Ruling 2014/5 (TR 2014/5).
TR 2014/5 adopts the view that any payment by a private company to an individual spouse pursuant to a Family Court order will not satisfy the second limb of section 109J – specifically, the Tax Office considers that in the context of a property settlement, the parties are not dealing at arm’s length.
In particular, Example 5 of TR 2014/5 (paragraphs 23-26) reads as follows:
‘In the 2014 income year, Sam, Martha and ABC Coy are parties to matrimonial property proceedings before the Family Court. Sam is the sole shareholder of ABC Coy which is the vehicle for the family business and has retained profits of $200,000. The distributable surplus of ABC Coy as worked out under section 109Y of the Tax Act 1936 is greater than $100,000.
On 29 May 2014, the Family Court makes a section 79 order for ABC Coy to pay Martha $100,000. On 30 June 2014, ABC Coy makes the payment of $100,000 to Martha in compliance with the Family Court order.
The payment to Martha is a payment as defined in paragraph 109C(3)(a) of the Tax Act 1936. Section 109J of the Tax Act 1936 does not prevent section 109C operating to treat the payment as a deemed dividend.
The payment of $100,000 is assessable to Martha as a dividend under section 44 of the Tax Act 1936, by virtue of section 109C of the Tax Act 1936.’
The Tax Office concludes in TR 2014/5 that any payment or transfer of assets by a private company to an individual spouse will trigger a deemed dividend under Division 7A, where the spouse is a shareholder or associate of a shareholder.
As a result, any requirement for a private company to pay an amount to a spouse as a result of family law proceedings should ideally be structured as a dividend (which allows franking credits to be attached), rather than risk triggering Division 7A.
For further information, please contact Patrick Ellwood on 0400 503 111 or patrick@cloverlaw.com.au.
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