Division 7A: Impenetrable or vulnerable? The jury is still out

Division 7A: Impenetrable or vulnerable? The jury is still out
June 16, 2017 Toohey Reid

The following article was written by Stephen Toohey, Peter Donovan and Damien Erbacher, and published in the Thomson Reuters Weekly Tax Bulletin (issue 26) on the 16 June 2017.

The ATO aggressively pursue many private group structures where those structures typically consist of a series of related private companies and trusts.  Each of these types of entities generally perform specific but different functions given their particular attributes.  The ATO often relies on Division 7A of the ITAA 1936 in seeking to extract more tax from these groups than is arguable payable.  A close analysis of Division 7A indicates that its operation is either uncertain or not as the broad as the ATO suggest leading to the conclusion that taxpayers should not automatically accept the ATO’s position.


The well publicised changes to Division 7A, both legislatively and administratively, have lead many advisors to wonder whether simply recommending a corporate structure to a client may make everybody’s life easier.

Given the change in the administrative treatment to UPEs and their uneasy interaction with the interposed entity provisions contained within Division 7A, surrendering the ability to claim the CGT discount may in some instances be considered to be a reasonable quid pro quo in transitioning into a corporate structure, leaving aside any transaction costs that may be incurred in making the transition.

However, standing back from the cacophony of rules that constitute Division 7A for a moment, the above conclusion begs the question as to the inherent strength of Division 7A and its largely untested ability to deliver on many of the warnings that constantly emerge from the Commissioner.

Indeed, a closer analysis of Division 7A potentially reveals a number of inherent weaknesses, which, for strategic or other reasons, have not been litigated by the Commissioner with a view to providing taxpayers with any level of certainty as to the proper reach of the Division.

Section 109W(2) of the ITAA 1936

One such provision worthy of closer analysis is s 109W(2) of the ITAA 1936.

As far as is relevant, s 109W states as follows:

“Private company taken to lend if target entity receives loan

(1) If the target entity is lent an amount by the interposed entity, this Division operates as if the private company had made a loan (the notional loan) of the amount (if any) determined by the Commissioner to the target entity when the interposed entity made the loan to the target entity.

How big is the notional loan?

(2) In determining the amount of the notional loan, the Commissioner must take account of:

(a) the amount the interposed entity lent the target company; and


(b) how much (if any) of that amount the Commissioner believes represented consideration payable to the target entity by the private company or any of the interposed entities  for anything (assuming that the consideration payable equals that for similar transactions at arm’s length).”

On its face, s 109W(2) draws from the law of contract in referring to the “consideration” paid or payable to the target entity by the private company.

As a matter of statutory construction, there appears to be no reason to suggest that a meaning other than its technical legal meaning should be adopted.

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Using the law of contract as a launching pad in understanding how s 109W(2) operates, the following hypothetical example throws up some interesting questions which serve to strike at the very utility of the provision.  Curiously, the provision may be so strong as to effectively weaken the operation of Division 7A generally, given that s 109W(2) operates as an exclusionary or reduction type provision.

Hypothetical example – secured loan arrangements

Assume, in a non-consolidations context, fully franked dividends are streamed from a head company (ABC P/L) to a subsidiary company through to a discretionary trust with a UPE then created in favour of a bucket company, with an actual secured loan in the sum of $1 million made by the discretionary trust to a related individual (Mr Smith).  The collateral offered is unencumbered real property.

Relevantly, clause 3.2 of the Loan Agreement states as follows:

The lender [ABC P/L] shall not advance the Loan Amount or any part of it unless and until the Borrower [Mr Smith] has first delivered to the lender, in a form and in substance satisfactory to the lender this Agreement and each and every Security duly signed and delivered by the Borrower and/or Security Provider and such other person as may be required to perfect the Security“.

The contents of the Loan Agreement, which is not made on section 109N terms, is also supported by an oral promise made by Mr Smith to enter into a security arrangement with ABC P/L in the event that it were to lend him monies, which it has.

Instead of attacking the UPE, the Commissioner relies on s 109T to deem a notional loan to have been made from ABC P/L to Mr Smith.

The issue for consideration is whether, or to what extent, s 109W(2) potentially operates to reduce the quantum of the notional loan that would otherwise be subject to tax.

The Commissioner’s view on the operation of s 109W(2)

In TD 2011/16, the Commissioner in part deals with the “consideration” point, as it appears in s 109W(2)(b), by stating that he will take the following into account:

“… how much (if any) of the amount loaned or paid to the target entity by an interposed entity under the arrangement the Commissioner believes represented arm’s length consideration payable to the target entity by the private company or an interposed entity for anything (other than its right to receive repayment of the loan and any relevant interest).

[emphasis added]

The above emphasised words do not appear in s 109W(2).  Instead, they have been added by the Commissioner in TD 2011/16 presumably to indicate how he thinks the provision should work.  That is, according to the Commissioner, a right to receive an amount of principal or interest cannot constitute “consideration” for the purposes of s 109W(2).

The authors doubt the accuracy of this position and are not alone.  We note that the Board of Taxation in its 2012 report entitled “Post Implementation Review of Division 7A of Part III of the Income Tax Assessment Act 1936”, provides a window into the difficulties associated with the operation of s 109T and 109W(2), as follows:

4.106 Subsection 109T(1) may be relatively straightforward to apply if there is a direct correlation between the transactions.  However, that will not always be the case.  There may be a number of transactions involving multiple private companies and multiple target entities in the arrangement(s).  The application of section 109T in these cases is uncertain.  However, it can be difficult to provide more prescriptive provisions that are sufficiently flexible to deal with the complex arrangements that may arise.

. . .

4.111 The target entity or recipient of the notional transaction is not required to make a judgement on quantum or to self-assess a deemed dividend. It is not clear whether the policy intent was that all arrangements involving interposed entities should be referred to the Commissioner.  The requirement for the Commissioner to determine the amount of the deemed payment or notional loan in all cases involving interposed entities is not consistent with self-assessment.  It has also been argued that without a determination by the Commissioner the amount is nil.

. . .

4.113 One of the factors that the Commissioner must take account of is how much (if any) of the amount the Commissioner believes represented consideration payable to the target entity by the private company or any of the interposed entities for anything.  Theoretically, the right to receive repayment of the loan and any relevant interest is consideration for anything.”

[emphasis added]

More questions raised than answers provided

In attempting to predict the tax outcome of the above hypothetical example, and particularly whether s 109W(2) operates to reduce the quantum of the notional loan that may otherwise arise under s 109T, a number of questions need to be considered, including the following:

  • does the oral promise made by Mr Smith operate to reduce the quantum of the notional loan made by ABC P/L to Mr Smith?
  • do the principal and interest payments made or to be made by Mr Smith under the Loan Agreement operate to reduce the quantum of the notional loan made by ABC P/L to Mr Smith?
  • does the provision of security by Mr Smith pursuant to clause 3.2 of the Loan Agreement operate to reduce the quantum of the notional loan made by ABC P/L to Mr Smith?


It is certainly arguable that the nature or species of consideration that is the subject of s 109W(2)(b) can be anything that is recogniszed as consideration pursuant to the law of contract.

If this is so, it would not be difficult to structure arrangements to ensure that “adequate” consideration was provided in a loan scenario to mitigate the potential operation of s 109T by bolstering the effectiveness of s 109W(2).  Hence, in some instances, the notional loan may be reduced to nil.

In any event, it is fair to say that this issue is attended with sufficient litigation risk on both sides of the fence to warrant a test case being run to obtain some authority on point.

Whether the Commissioner is prepared to take that risk is another matter.

Alternatively, if the Commissioner considers that this is not how the law was intended to operate, he could petition for legislative change.  This would appear to be a better approach than attempting to put a particular slant on the provision by purporting to add words to the provision via a taxation determination and in so doing arguably providing a construction which is not in accordance with the law.

General Advice Disclaimer

General advice warning: The advice provided is general advice only as, in preparing it we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this advice, you should consider how appropriate the advice is to your particular investment needs, and objectives. You should also consider the relevant Product Disclosure Statement before making any decision relating to a financial product.

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