The Australian Taxation Office (ATO) recently issued two key updates that could affect private groups using guarantee-backed financial arrangements.

Draft Taxation Determination TD 2024/D3 (Draft TD) and Taxpayer Alert TA 2024/2 (TA) discuss section 109U of Division 7A of the Income Tax Assessment Act 1936, that targets loans, payments, and guarantees involving private companies and their shareholders or associates.

Here is what you need to know.

What is the Issue?

Division 7A aims to prevent private companies from distributing untaxed profits to shareholders or their associates under the guise of loans, payments, or forgiven debts. The Draft TD and the TA give the ATO views, and a warning, on how the ATO interprets section 109U where loans and payments involve guarantees.

The ATO views in the Draft TD

The Draft TD sets out the ATO views on section 109U and how it will apply its compliance resources to arrangements involving guarantees. Under section 109U, a private company is taken to make a payment to a shareholder or associate of a shareholder (target entity) if:

• the private company guarantees a loan made by another entity (first interposed entity);

• a reasonable person would conclude (having regard to all the circumstances) that the private company gave the guarantee solely or mainly as part of an arrangement involving a payment or loan to the target entity;

• another private company (which may be the first interposed entity or another interposed entity) makes a loan or payment to the target entity; and

• the amount paid or loaned by the other private company to the target entity exceeds that company's distributable surplus.

The ATO view in the Draft TD is that the first interposed entity under section 109U(1)(a) does not need to be a private company and could include public companies or banks. However, the Draft TD stresses that the entity making the payment or loan to the target entity must be a private company, as specified in section 109U(1)(c).

Both these views appear consistent with the literal drafting of section 109U.

Section 109U is complicated. The example in the Draft TD gives a circumstance when section 109U could apply.

• The Fruit family wholly own several private companies, including Orchard Co and Apple Co;

• On 1 November 2023, Orchard Co provides a guarantee to Bank Co for a $100,000 loan to Apple Co. Bank Co is a publicly listed company;

• On 4 November 2023 Apple Co transfers $100,000 to Sarah for her personal use. Apple Co is a newly incorporated entity and has no distributable surplus for Division 7A purposes;

• As Apple Co is a private company and ultimately pays the amount to Sarah, subparagraph 109U(1)(c)(ii) is satisfied. The ATO considers having regard to all circumstances, section 109U applies to deem Orchard Co to make a payment to Sarah.

Implications of the Draft TD

Taxpayers often overlook section 109U with the focus on loans (and UPEs), payments, and to a lesser extent forgiveness of debts. While section 109U includes a ‘reasonable person’ test, the section could inadvertently apply to arrangements between entities in private groups.

The Draft TD says that the ATO will apply its compliance resources concerning the application of section 109U to high-risk arrangements that exhibit clearly artificial or contrived elements. While that may provide a degree of comfort around section 109U, taxpayers and the ATO views on what is ‘artificial and contrived’ may differ.

Submissions on the Draft TD close on 31 January 2025.

Irrespective of the outcome of the submission process, private groups should carefully review their financing arrangements to ensure that section 109U does not apply to avoid unexpected tax consequences.

Red flags highlighted in the TA

The TA accompanied the Draft TD and set out arrangements “that typically display the following features”:

• A private company (Trading Co) guarantees a loan made to a related private company (Lending Co) from a third-party financier that is not a private company, such as a bank;

• Lending Co pays or loans some or all the amount borrowed to the shareholders of Trading Co (or the shareholders' associates). If Lending Co does make a loan, it fails to meet the compliance requirements outlined in section 109N;

• The payment or loan made by Lending Co is more than its distributable surplus;

• Trading Co may pay the amounts required under the loan agreement with the third-party financier because Lending Co defaults on its obligation to repay the amounts required under the loan agreement to the third-party financier and calls on the guarantee of Trading Co;

• Alternatively, Trading Co may pay the amounts required under the loan agreement with the third-party financier directly or pay money to Lending Co to enable it to repay the third-party financier, and to prevent Lending Co from defaulting on its obligations under the loan agreement;

• On an objective assessment, Trading Co's guarantee and Lending Co's loan were provided as part of the same contrived arrangement for the purpose of avoiding the Division 7A consequences that would have arisen had Trading Co directly paid or lent the amount to its shareholders (or their associates);

The ATO is concerned that arrangements of this type are being used to defeat the operation of the payment and loan rules in sections 109C and 109D of Division 7A.

While section 109U includes a ‘reasonable person’ test, which is an objective test, the ATO’s view on what is reasonable (or not) may mean that arrangements are subject to compliance action irrespective of the final outcome of that activity if it were considered by a court or tribunal.  

What is next?

The Draft TD is, by definition, still in draft, and the ATO is seeking public comments by 31 January 2025 before issuing a final determination. Once finalised, it will apply retrospectively to past and future income years. The TA is not in draft.

With the focus in 2023, 2024, and into 2025 on ‘Bendel and UPEs’, the Draft TD and the TA remind us that section 109U, and the rest of the interposed entity rules in Subdivision E of Division 7A, extend the scope of Division 7A beyond direct payments and loans regardless of the outcome of that litigation.

Given the ATO’s heightened compliance focus, businesses should revisit existing financial arrangements and consider seeking professional advice to manage Division 7A risks.

Our experienced tax team at Sladen Legal can help with reviewing your company’s financial structures, ensuring compliance, and managing ATO reviews.

For more information or assistance, please contact:

Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 |  T +61 3 9611 0105
E dsmedley@sladen.com.au

Neil Brydges
Principal | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E nbrydges@sladen.com.au

Kaitilin Lowdon
Principal Lawyer
M +61 402 859 214 | T+61 3 9611 0120
E: klowdon@sladen.com.au

Kseniia Gasiuk
Associate
T +61 3 9611 0160
E kgasiuk@sladen.com.au