When is a company loan an actual loan? ATO guidance on debt deductions

This article was current at the time of publication.

The Australian Taxation Office (ATO) has been strengthening its application of Division 7A of the Income Tax Assessment Act 1936 for some time.

Division 7A requires that payments made by private companies or trusts to shareholders or associates must be designated as loans to be compliant, and subject to annual repayments and interest charges, or they will be deemed by the ATO to be dividends for tax assessment purposes.

The ATO’s main focus has been to scrutinise arrangements where interest-free cash payments or assets have been transferred by entities to related individuals without any repayment or return obligations in place.

The regulator may charge penalties and interest on unpaid tax where there has been a deemed dividend under Division 7A. Franking credits cannot attach to the deemed dividend.

But the application of Division 7A remains contentious. Last year the Administrative Appeals Tribunal ruled against the ATO in Bendel v FCT [2023] AATA 3074, finding that unpaid present entitlements (UPEs) owed to a company (in this case, amounts owed between a trust and a corporate beneficiary) did not constitute a Division 7A loan. 

The ATO appealed that ruling to the full bench of the Federal Court, which is still to hand down a judgment after hearing arguments from the ATO in August that UPEs should be taxed as deemed dividends under the canopy of Division 7A.

Division 7A and DDCR

Another facet of Division 7A has now arisen as a result of Federal Government amendments that were passed into law in April to meet Australia’s interest limitation (thin capitalisation) rules that became effective on 1 July 2023.

The changes incorporate the debt deduction creation rules (DDCR) contained in Subdivision 820-EAA of the Income Tax Assessment Act 1997 that deny debt deductions arising in connection with relevant related party arrangements from 1 July 2024.

The DDCR applies to multinational businesses (businesses operating in Australia and at least one other jurisdiction), including private businesses and privately owned groups.

The rules aim to reduce the ability for multinationals with at least A$2 million in debt deductions (on an associate inclusive basis) in an income year to create debt through internal transactions in order to claim debt deductions in Australia.

“This is a sort of a suite of rules which deny debt deductions to the extent that they’re incurred in relation to an arrangement that lacks genuine commercial justification,” says ATO Assistant Commissioner (Client Experience), Louise Clarke.

“A classic scenario is where you might have a taxpayer in Australia borrow from a related party to fund an acquisition of an asset from another related party. 

“So, you can see, in that sort of situation that the parties are all related, the transactions are all within their control. There is money that’s within the group that’s there, which could be injected by way of equity, but a scheme arrangement has created debt deductions.

“That’s the mischief. The government decided that they would counter or deal with those debt creation schemes by putting in these debt creation rules. There are now tests and criteria that are all in the thin capitalisation rules which trigger when these rules will apply and when a debt deduction will be disallowed.”

Impacts on Division 7A loans

The ATO has released new guidance on the DDCR and Division 7A, which stipulates that even complying Division 7A loans are not excluded from the operation of the DDCR.

“Where the conditions of the DDCR are met, they will operate to disallow a deduction for interest paid or payable under a complying Division 7A loan where that loan has been used to acquire or fund a relevant related party arrangement,” the ATO states.

“Even if a loan is compliant with Division 7A, it does not exempt the entity from the operation of the DDCR. Privately owned groups should consider whether the DDCR operates to disallow debt deductions for their related party debt arrangements.”

Clarke says the DDCR and Division 7A regimes are separate and distinct, so both can apply.

The DDCR applies to any loans between related parties that result in the generation of Australian debt deductions, whether they be cross border loans or wholly domestic loans. Division 7A can apply regardless of whether a company paying distributions to shareholders or associates is in Australia or in another jurisdiction.

“It is possible that you might have a loan which is subject to the debt creation rules, because it satisfies the criteria it doesn’t have commercial justification, which is also going to be subject to Division 7A.”

Pitcher Partners Melbourne Client Director, Leo Gouzenfiter, says Division 7A loans that give rise to interest and debt deductions might now be swept into the new debt deduction creation rules, even where the interest income derived by the lender company is fully taxable in Australia.

“While the measure has been touted as being targeted at transactions which lack commercial justification, the law has no regard for what the actual commercial justification of a particular loan might be. 

“The purported lack of commercial justification is a deemed one, even where there is no mischief at all and there is a perfectly cogent commercial rationale,” Gouzenfiter says.

“Further, the law doesn’t limit these debt deduction creation rules to public companies, so if an Australian private company has a foreign footprint, however minor, you might have to be concerned about these new integrity rules for things like Division 7A loans as well as any other intra-group interest-bearing loans wholly within the domestic group and which have nothing to do with the foreign investment. 

“The rules can apply to ordinary transactions with no cross-border elements. In particular, discretionary trusts commonly require internal funding from private groups using Division 7A loans as they cannot issue equity in the same way as unit trusts or companies can.”

Gouzenfiter says that despite the new rules being targeted to large multinationals, there is such a thing as a small multinational.

“It could even be a small interest in a subsidiary of 10 per cent or a capital investment of a single dollar, and once you have that you’re basically treated as being a multinational for these purposes and you’re in these debt deduction creation rules no matter the size of that foreign presence.”

Yet Clarke says most small businesses will be excluded from the DDCR because they have A$2 million or less of debt deductions.

“That will take out pretty much all small business, and the bottom end, I would imagine, of the private wealth market.”