Introduction
There are industry concerns that the Australian Taxation Office (ATO) will change the administrative practice of not applying Division 7A to qualifying payments made by a private company to a former spouse under court order or agreement when draft Ruling TR 3630 is issued in November 2013:
Legislative references are to Income Tax Assessment Act 1936 (ITAA 1936), Income Tax Assessment Act 1997 (ITAA 1997), the Taxation Laws Amendment (2007 Measures No. 3) Act 2007 (TLAM 3 2007), the Family Law Act 1975 (FLA 1975) and the Relationship Act 2008 (Vic) (RA 2008).
Private Company Payments
A payment by a private company to a former spouse on marriage or relationship breakdown will constitute a dividend, if the former spouse is a shareholder (s. 44 ITAA 1936) or a constructive dividend because the former spouse is an associate of a shareholder (s. 109C ITAA 1936) unless exempt.
The marriage or relationship breakdown rollover which defers any capital gain tax where a company transfers an asset to a former spouse under qualifying FLA 1975 or RA 2008 court orders or agreements (s. 126-15 ITAA 1997) does not exempt the dividend or constructive dividend. A payment of Australian currency is not subject capital gains tax (TD 2002/25).
A private company is not taken to pay a constructive dividend to the former spouse to the extent that the payment discharges an obligation of the private company to pay the money to the former spouse and the parties were dealing with each other at arm’s length (s. 109J ITAA 1936).
If a dividend is taken to be paid under Division 7A because of a family law obligation, the dividend can be franked and the former spouse is treated as a shareholder in the private company (s. 109RC ITAA 1936; s. 109ZD ITAA 1936 & s. 126-5 ITAA 1997).
It is common practice to retire a former spouse as a shareholder so that the subsequent payment by a private company to the former spouse is not a dividend and only Division 7A ITAA 1936 needs to be managed. The ATO has not applied the general anti-avoidance provision (Part IVA ITAA 1936) in these circumstances.
The private company does not have to be a party to the court order and may be bound indirectly by a third party order for CGT rollover under s. 126-15 ITAA 1997. The private company must be a party to the court order under s. 109J ITAA 1936.
Under the FLA 1975, the court can join the private company as a named party to the legal proceedings and make direct orders requiring the private company to make the payment to the former spouse. Under third party orders (e.g. s. 79 FLA 1975), the private company does not become a named party to the legal proceedings and the court orders require the directors and shareholders of the private company to cause the private company to make the payment to the former spouse.
Where s. 109J ITAA 1936 is applied, the payment is not franked and, although the private company retains the franking credit account balance, it is very difficult to subsequently utilise those franking credits other than on liquidation. Accordingly, the private company may prefer to frank the distribution under s. 109RC ITAA 1936 than apply s. 109J ITAA 1936.
Also, it is unclear whether application of s. 109J ITAA 1936 is automatic if the provision is satisfied. If application of s. 109J ITAA 1936 is automatic, then s. 109RC ITAA 1936 could not be applied even if the private company wanted to frank the distribution. If s. 109J ITAA 1936 applies, s. 109J ITAA 1936 states that a private company is not taken to pay a constructive dividend. Section 109RC ITAA 1936 only ‘applies if a dividend is taken to be paid under this Division…’.
Accordingly, it is common practice to only obtain third party court orders where the payment is to be franked so that s. 109J ITAA 1936 cannot apply automatically because the private company is not a party to the legal proceedings.
ATO View
The long held ATO position was that a transfer of money (not property) by a private company which is a party to a FLA 1975 or RA 2008 court order to a former spouse is not a constructive dividend (e.g. Private Binding Rulings PBR 1011434884971, PBR 1011437352778; PBR 85827, PBR 54305 PBR 54306 & 54306, PBR 46679 & 46680, PBR 69302, PBR 1011509693406; cf ATO ID 2004/462; PBR 61876).
TLAM 3 2007 enacted s. 109RC ITAA 1936 permitting franking of dividends under family law obligation.
The stated reason for draft TR 3630 is to reflect the following policy statement in the explanatory memorandum to TLAM 3 2007:
1.44 Under the current law, transfers of property and other ‘payments’ in respect of marriage or relationship breakdown are caught by Division 7A even though they may be non-voluntary (eg, due to a court order). As such a deemed dividend may arise.
The example given in the explanatory memorandum to TLAM 3 2007 was:
Example 1.14
Jack and Stephanie divorce. Stephanie owns and controls private company BCD Pty Ltd. The Family Court orders Stephanie to transfer the private company’s motor vehicle to Jack as part of the property settlement. This transaction will trigger a deemed dividend under Division 7A. The amendments will allow the dividend to be franked like other dividends that the private company declares in the income year that it transfers the motor vehicle to Jack.
The orthodox view is that payment of money under a complying family law obligation by a private company is not a constructive dividend under s. 109J ITAA 1936. If s. 109J ITAA 1936 does not apply (e.g. the payment was a transfer of property or the private company was only subject to a third party court order) or the parties preferred to frank the distribution, the distribution could be franked by an appropriately drafted complying family law obligation under s. 109RC ITAA 1936.
In this context, draft TR 3630 could be seen merely as an opportunity to consolidate the ATO’s views expressed in numerous non-binding Interpretative Decisions and Private Binding Rulings and to clarify the factors and operation of and relationship between s. 109J ITAA 1936 and s. 109RC ITAA 1936 in an administratively binding publication (TR 2006/10).
However, recently concerns have been raised that the ATO is interpreting the policy restrictively on the basis that s. 109RC(1) ITAA 1936 applies to the exclusion of section 109J ITAA 1936 so that the dividend can only be franked and is not exempt under s. 109J ITAA 1936.
This would be a significant change in ATO position and is contrary to a proper construction of the provisions and the relationship between the provisions.
Conclusion
Hopefully the recent concerns are unfounded or industry bodies can modify the ATO’s new interpretation.
In the interim, it would be prudent to only rely upon the application of s. 109J ITAA 1936 after obtaining private binding ruling.