Seek guidance when executing a new Division 7A loan agreement where loan agreements already exist

By Alexis Kokkinos - June 27, 2019

Care should be taken when executing new Division 7A loan agreements as it can result in a deemed dividend where loan agreements already exist, and double deemed dividends where the new loan agreement is also not complied with. In a recent decision, the Administrative Appeals Tribunal (AAT) held that a replacement loan agreement, intended to ensure compliance with Division 7A, actually created a new loan. The consequence of this would have been that the old loan would not be taken to have been repaid resulting in deemed dividends on the old loan.

Do not hesitate to contact your Pitcher Partners representative to review these arrangements and determine how the AAT’s views on this election may apply to your own situation.

What was the case about?

The taxpayer in KKQY v Commissioner of Taxation (Taxation) [2019] AATA 204 (“KKQY”) borrowed $2.2 million from a family company under an agreement entered into in 2005. The terms of the 2005 loan agreement did not satisfy the requirements of Division 7A. Realising the potential tax exposure, the taxpayer and the private company entered into another loan agreement in 2007 in respect the balance then outstanding. The terms of the 2007 loan agreement did satisfy the requirements of Division 7A.

The issue raised by the facts was whether the 2007 agreement amounted to a new loan or merely varied the terms of the 2005 agreement. The ATO determined that the 2007 agreement was a new loan. The AATA agreed with that conclusion.

What was the basis of the decision?

Relevant case law establishes that the parties to an agreement may, by a subsequent agreement, vary or rescind the earlier agreement. In the absence of a clear statement in the later agreement, the determining factor is the objective intention of the parties as disclosed by the terms of the later agreement.

Guided by that principle, the AATA held that the 2007 agreement amounted to a rescission of the 2005 agreement on the basis that: (a) the 2007 agreement was a discrete agreement which could be sued upon without reference to the 2005 agreement; and (b) the 2007 agreement replaced all of the fundamental terms of the earlier agreement including the period of the loan and rate of interest payable.

The AATA upheld the imposition of the 50% shortfall penalty as the taxpayer was aware of the requirement for the 2005 loan to be compliant with Division 7A and of the repayment required to be made during the 2012 year. Further, the taxpayer did not provide any evidence or explanation as to why the repayment obligations were not met.

What is the technical analysis underlying the decision?

The ATO explored the Division 7A consequence of a later loan agreement rescinding and replacing an earlier agreement in ATO Interpretative Decision 2012/60.

Adapting the comments in that Interpretative Decision to the facts in KKQY the effect of the rescission is that the balance outstanding under the 2005 agreement is notionally repaid and replaced by a new obligation at the time the 2007 agreement was entered into. However, under section 109R, repayments are disregarded for Division 7A purposes where the same or a similar amount is reborrowed from the company.

For Division 7A purposes, this means that the existing loan therefore remains on foot from a tax (but not a contractual) perspective and, subject to the Commissioner exercising a discretion provided by section 109RB, can give rise to a deemed dividend where the loan is not complied with.

What about the new loan?

Having replaced the 2005 agreement, the application of Division 7A to the 2007 agreement then requires consideration. The facts disclose that the taxpayer did not meet the minimum loan repayments on the new loan and thus the taxpayer was assessed to a deemed dividend of that shortfall amount. Accordingly, the case demonstrates that a taxpayer may be assessed on deemed dividends under both the old and new loan.

Is there a way to avoid a deemed dividend on the replaced loan?

The provisions only provide two ways to deal with such a circumstance. The first mechanism allows ‘dividends’ paid by the company to be offset against prior loans that were treated as deemed dividends. Section 109ZC provides that the actual dividends are not assessable to the extent of the offset. The problem with this provision is that it only allows unfranked dividends to be paid. Accordingly, the provision is merely administrative rather than providing real relief (i.e. it allows loans to be cleared from the books).

The second mechanism is requesting relief from the Commissioner under section 109RB. While the decision in KKQY is silent on the application of the discretion, the Commissioner states the following in ATO ID 2012/60.

Note: In cases where a deemed dividend is the result of an honest mistake or inadvertent omission, taxpayers can apply to the Commissioner to exercise his discretion under section 109RB to either disregard the Division 7A result or allow the deemed dividend to be franked. In making a decision the Commissioner must have regard to the factors listed in subsection 109RB(3) and may make a decision subject to conditions.

While this paragraph offers no more than a summary of the discretion, taxpayers may need to seek the exercise of the discretion to ensure that the replacement of the loan does not inadvertently result in double deemed dividends.

Could the loan agreement be drafted in a different manner?

Yes. First, most loan agreements allow the parties to agree that a new Division 7A loan agreement does not cover existing loans. We would recommend that taxpayers consider this clause when entering into new Division 7A agreements.

Second, it is also possible to amend an existing loan agreement to ensure it complies with Division 7A (without replacing the loan agreement). Where this occurs, the issues outlined in KKQY should not occur. This is recognised by the ATO in ATO ID 2012/61.

What happens if you change from a 7-year loan to a 25-year loan?

The refinancing rule contained in section 109R provides an exception where a 7-year Division 7A loan is refinanced and a new 25-year loan is put in place (which meets the requirements to be a qualifying replacement loan). An exception is also allowed for the reverse scenario. Accordingly, the decision in KKQY should not impact on the ability to refinance these type of loans.

What are the next steps?

The decision in KKQY needs to be kept in mind where Division 7A loan agreements are being put in place for 30 June 2018 and 30 June 2019. This issue will also become particularly relevant when we transition loans from the current set of Division 7A provisions to the proposed new provisions.

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