Ref: AMK:lg
31 January 2025
Anthony Pulvirenti
Australian Taxation Office
GPO Box 9997
MELBOURNE VIC 3001
pitcher.com.au
By Email: Anthony.Pulvirenti@ato.gov.au
Dear Anthony
TD 2024/D3
1. Thank you for the opportunity to provide comments on Draft Taxation Determination TD 2024/D3 (“TD 2024/D3”) in relation to the application of section 109U of the Income Tax Assessment Act 1936 (Cth) (“ITAA 36”)1
2. Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we service many taxpayers that would be impacted by the ATO’s release of public guidance on section 109U.
3. We highlight that for the purposes of Division 30 of the Tax Agent Services Act 2009 (Cth) (“TASA 2009”) and, in particular, the amendments made to the Code of Conduct by the Tax Agent Services (Code of Professional Conduct) Determination 2024 , all of the comments made in this submission are directly relevant to us as a firm and our clients. While this may result in a conflict of interest for the purposes of section 20 of the Determination, we highlight that we have tried to ensure that our comments and suggestions contained in this submission are balanced and consistent with the policy principles and intention of the rules as we understand them.
Correctness of view
4. We do not agree with the ATO’s interpretation of section 109U as contained in TD 2024/D3.
5. Contrary to paragraph 18 of TD 2024/D3, we are of the view that the second reference to private company in subparagraph 109U(1)(c)(ii) is a reference to the private
1 All legislative references in this document are to ITAA 36 unless stated otherwise.
company mentioned in subparagraph 109U(1)(c)(i) rather than the company that gave the guarantee in paragraph 109U(1)(a).
6. While TD 2024/D3 provides some extracts from the Explanatory Memorandum to the Bill which introduced section 109U, it does not explain how these comments support the ATO’s interpretation.
7. In our view, it is clear that for section 109U to operate, it must involve two separate private companies, one with a sufficient distributable surplus and one with an insufficient distributable surplus. It is therefore primarily concerned with private companies guaranteeing loans made by other private companies. Subparagraph 109U(1)(c)(ii) merely extends the operation of section 109U where other entities are interposed between the recipient of the guarantee and the target entity. It does not replace the main operation of the provision to cover the provision of guarantees given to any kind of entity, related or unrelated.
8. In our view, section 109U is intended to be limited to guarantees provided to the private company with the insufficient distributable surplus. Where guarantees are provided to entities other than private companies (e.g. banks), these arrangements are expressly dealt with under section 109UA.
9. The ATO’s interpretation in TD 2024/D3 would appear to result in an arbitrary and inconsistent application of section 109U and (effectively) would suggest that the drafters did not fully adopt a coherent set of rules when drafting section 109U. That is, the ATO’s interpretation suggests that subparagraph 109U(1)(c)(ii) is intended to capture interposed arrangements involving bank guarantees. However, this paragraph would apply to a very small minority of interposed corporate guarantee arrangements and would not apply to the majority of interposed arrangements. For example, even under the interpretation contained in TD 2024/D3:
9.1. Section 109U would not apply to a basic case where a private company guarantees a loan that is made directly by a bank to an individual (i.e. paragraph 109U(1)(c) will not be satisfied).
9.2. Section 109U would not apply where a private company guarantees a loan that is made by a bank to an interposed corporate entity that is a trustee of a trust. Section 109ZE will not treat the interposed entity to be a private company for the purposes of the Division (see also the note to section 109K as an example).
10. We do not believe that the ATO could credibly argue that the intention of the drafters and the correct interpretation of the provision is one in which subparagraph 109U(1)(c)(ii) was included to deal with one particular kind of guarantee arrangement, rather than providing a general extension allowing for tracing of loans and/or payments from the borrower (i.e. the interposed private company that received the guarantee) out to the ultimate target entity. It is implausible that by including subparagraph 109U(1)(c)(ii) the Treasury was solely focused on arrangements involving an interposed no-distributable surplus company (e.g. a $2 company) borrowing from an unrelated party, but not any kind of other interposed entity. This is especially so given that section 109U is intended to extend the application of the general interposed entity rule in section 109T, which is not otherwise limited by in its application based on the type of entity that is interposed between a private company and a target entity.
11. We are in the process of obtaining further information about the implementation of Division 7A of Part III of the ITAA 36 (“Division 7A”), such as drafting instructions
provided by the Treasury. We will seek to provide further comments if this process identifies any further information that can assist with the above.
12. We note that the above differences of opinion become significantly more contentious due to the simple fact that the ATO has not provided any ‘safe harbour’ for complying with section 109U (where the case is not contrived and is a simple ordinary commercial business arrangement).
13. We believe that it is unacceptable (some 26 years after the provision was first introduced) to outline a new view on the operation of section 109U (which is inconsistent with the interpretation of the provision to date) without providing a practical or administrative way of dealing with the provision. The ATO view brings to question commercial transactions that have no mischief and are not arrangements which circumvent the operation of Division 7A. Simple business conduit financing arrangements (where a single company obtains finance for the whole of the group) would be caught within TD 2024/D3, without any conclusion as to how section 109V would apply to the arrangement. As section 109V is not self-executing and requires a determination by the Commissioner, it is our view that an inconclusive public ruling on this topic would create significant uncertainty for taxpayers and would not be viewed as good administration. This can be compared to Taxation Determination TD 2011/16 (“TD 2011/16”), which provided detailed guidance on how to administer the interposed entity provisions without having to apply to the Commissioner. Accordingly, the lack of safe harbour will place significant pressure on the technical issue outlined above, especially where the background facts are identified by ATO staff as being similar to those in the TD 2024/D3.
14. Whether or not TD 2024/D3 contains the correct technical interpretation should however not have significant practical impact if the ATO adopts sensible safe harbours in its guidance as we outline below, including where:
14.1. The loan to a target entity is made on complying Division 7A terms;
14.2. The loan to a target entity is made in order to comply with the conduit financing conditions in the thin capitalisation rules; or
14.3. The loan to a target entity is otherwise made on commercial terms that reflect those provided by a bank or financial institution.
15. Given that all of the above outcomes can be achieved by using a $2 company acting as trustee (i.e. that is not within the scope of subparagraph109U(c)(ii)), we do not believe that it should be difficult to provide these exceptions, which is consistent with TD 2011/16. This is explained further below.
Safe harbours
16. As outlined above, we are concerned that the Commissioner has chosen not to provide any safe harbour approach to taxpayers. Where the last loan in the arrangement (i.e. the loan to the non-corporate target entity) is on complying Division 7A terms and the target entity has the intention and capacity to repay the loan, the amount of any notional payment under section 109V should be determined as being nil.
17. Division 7A is an area of the tax law that affects common private group structures that contain a combination of companies, trusts, partnerships and individuals that are “associates”2 of each other.
18. Many private groups borrow from banks via a single group financing company which then on-lends the borrowed amounts to group entities such as trusts. Those bank loans are generally required to be supported by guarantees and/or other forms of security given by other entities in the group. Invariably, this requires all entities with assets in the group to provide a cross-guarantee, which may include trusts and corporate entities.
19. Transactions of this kind are very common and are ordinary commercial financing arrangements. The view in the TD 2024/D3 means that those arrangements are now at risk of being treated as deemed dividends, regardless of whether the guarantee or security is ever called upon. We note that the outcomes are also random, depending on the structure chosen. If the group happens to have used a $2 trustee company as the conduit financier for the group, the ATO interpretation will not apply. If the group happen to use a $2 (non-trustee) corporate, the ATO’s interpretation may then apply.
20. To date, most practitioners have operated on the understanding that Division 7A only applies where one private company guarantees (or provides security) for a loan made by a related private company, but not for a loan made by a third party such as a bank. It is generally understood that guarantees of bank loans by private companies are governed exclusively by section 109UA, rather than section 109U. Accordingly, it is critical that the ATO provide appropriate safe harbours (that can be supported by the legislation, rather than just administratively).
21. It is therefore important for the ATO’s determination to state that section 109U should only apply to result in an assessable deemed dividend in very limited circumstances (i.e. by limiting its operation through subsections 109V(1) and (2) consistent with TD 2011/16). This is explained further below.
22. Section 109U operates by deeming a notional payment for the purposes of section 109V. Like other provisions in the interposed entity rules in Division 7A, section 109V requires a determination by the Commissioner regarding the amount of the payment. We do not believe it is in the interest of the ATO to require all taxpayers to obtain a Commissioner’s determination where they have entered into bank guarantee arrangements.
23. While the Commissioner has released TD 2011/16 to provide guidance on the amount of the payment or loan under section 109V for the purposes of section 109T, this guidance does not cover a situation involving section 109U. Accordingly, taxpayers cannot rely on TD 2011/16 and cannot self-assess or manage risk with respect to guarantee arrangements. One of the important considerations in TD 2011/16 is whether a loan to an interposed entity is placed on complying Division 7A terms.
24. It is critical that the ATO provides clear and binding guidance to address this ambiguity and facilitate practical compliance.
25. In particular, where a loan in the arrangement (i.e. to a non-corporate target entity) is on complying Division 7A terms, and none of the features in paragraph 3 of TD 2011/16 are present, the amount of any notional payment under section 109V should be determined as being nil. We note that section 109X is not capable of being applied to
2 As defined in section 318
section 109V as a statutory exclusion in the same way it applies to ordinary back-toback loans that result in a notional loan under section 109W. This approach aligns with the comments in Appendix 2 of TD 2024/D3 that the ATO will focus on "high-risk arrangements that display clearly artificial or contrived elements."
26. Given that the ATO is generally comfortable with its conclusions in TD 2011/16, we do not believe that (prima facie) it would be difficult for the ATO to simply include a statement (in the binding section) that says that the ATO will look to apply the same factors as contained in paragraphs 1 to 4 of TD 2011/16, in applying the final version of TD 2024/D3. Furthermore, we would request an update (new paragraph 3A) that outlines that the factors can be applied for the purposes of considering 109V where the arrangement involves the application of section 109U.
27. This would also be consistent with the Taxpayer Alert TA 2024/2, which highlights a concern over contrived arrangements, specifically in circumstances where the loan out to the target entity is not on complying Division 7A terms.
Other commercial loans
28. In addition to a section 109N safe harbour, given that it has been some 26 years since this provision has been operational, the ATO should take an approach to the application of section 109V (to a section 109U arrangement) to result in a notional payment of nil in circumstance beyond merely those where loans are made to the target entity on complying Division 7A terms. Specific additional exceptions that should be considered are outlined below.
Interaction with the conduit financing rule
29. We highlight that the ATO’s view in the TD 2024/D3 would render the conduit financing rule in section 820-427C of the Income Tax Assessment Act 1997 (“ITAA 97”) inapplicable to private groups that use a corporate conduit financer.
30. That is, where a corporate conduit financer (e.g. a $2 interposed company) is used, the obligor group (as referred to in section 820-427A ITAA 97) will likely consist of other corporate entities within the private company group. The obligor group (by definition) will generally be required to provide a guarantee to the financial institution. In accordance with TD 2024/D3, this arrangement will now likely result in a deemed dividend, which would potentially restrict access to this provision for private company groups.
31. However, if the ATO were to provide an exception for section 109N loans to target entities (as recommended above), we highlight that this would still breach the conduit financing provisions. Under section 820-427C ITAA 97, the provision requires loans of the “conduit financer”, being the interposed private company, to be provided by the conduit to associate entities on the same terms as the loan it obtained from the financial institution (see paragraph 820-427C(1)(d) ITAA 97).
32. This is unlikely to be on terms equivalent to Division 7A (i.e. a bank would not likely lend on terms that match Division 7A). Accordingly, using Division 7A terms would likely result in the conduit financing rule not being able to be satisfied. If the conduit financer provides loans on terms equivalent to the bank’s terms, a deemed unfranked dividend is likely to arise unless other commercial terms are seen as acceptable from a section 109U and 109V perspective.
33. Subsection 820-427C(1) ITAA 97 has been drafted on the basis that the terms be the same as the bank debt finance and thus it is generally not possible for the loans to comply with Division 7A. Therefore, it will be difficult or impossible for private groups subject to the thin capitalisation rules to navigate both the conduit financing provisions as well as Division 7A if too narrow an approach is taken by the ATO to the application of sections 109U and 109V.
34. We strongly recommend that this be considered as a part of adopting this public advice to ensure that private groups are not disadvantaged due to this position. That is, the ATO should provide a binding view that determines the amount of any notional payment is nil where the target entity has borrowed from the conduit financier on terms that were put in place to satisfy the conditions of section 820-427C ITAA 97.
Other commercial lending terms
35. As stated above, it is common for a private group to borrow from a bank using a group finance company and for all entities within the group to provide a guarantee and/or security to the bank. If the “financier” entity is providing loans to other trust entities on an interest only basis (where interest is equal to or greater than the bank debt), we are not aware of the ATO seeking to apply paragraph 109U(1)(c) in any of these commercial circumstances.
36. In other circumstances (not involving the conduit financing rule in the thin capitalisation provisions), a group finance company may merely seek to replicate the terms of its own borrowings when it on-lends amounts to related entities within the group. This would usually be done for commercial purposes to ensure it is able to fund its own expenses and establish a clear nexus for deductibility of such costs. That is, it may be impractical to borrow from a bank and on-lend on Division 7A terms where the terms of the bank borrowing are significantly different.
37. Arrangements involving the interposed finance company on-lending amounts in a commercial manner (consistent to support the external finance arrangement with the financial institution) should also not result in a deemed dividend arising. Such arrangements, where there are no contrived features and where the target entity has a genuine capacity and intention to repay the loan should also be ones that benefit from a safe harbour by which the ATO will determine the amount of any notional payment under section 109V is nil.
38. As outlined above, we highlight the importance of obtaining practical guidance for this issue that does not target 99% of commercial arrangements for the sake of targeting 1% of arrangements that seek to exploit Division 7A. We also highlight that the ATO view can be easily circumvented by those looking to exploit the provisions by using an interposed trust rather than an interposed private company. Accordingly, those looking to exploit Division 7A are likely to restructure their arrangements, while those in genuine commercial bank lending arrangements will likely be required to apply an interpretation that is not aimed at such groups. Accordingly, having appropriate safe harbours for commercial arrangements is a critical requirement of TD 2024/D3.
If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8610 5170.
Yours sincerely
A M KOKKINOS Executive Director