Another Div 7A U-Turn by the ATO — Family Law and Tax collide

November, 2013

As widely reported, the Tax Office released Draft Taxation Ruling TR 2013/D6 (the Draft Ruling) on 13 November 2013. The Draft Ruling concerns the treatment of payments by a private company arising from matrimonial property proceedings under Div 7A of ITAA1936 for under market value.

The Draft Ruling expresses the Tax Office’s view that s 109J of ITAA1936 cannot, in any circumstances, apply to a payment made by a private company to shareholder or an associate of a shareholder in satisfaction of orders under s 79 of the Family Law Act 1975. The Tax Office therefore concludes that Div 7A applies to such a payment (ie it is not excluded under s 109J), Thus, such a payment will be taxable to the recipient as a deemed dividend (although it is likely that the dividend will be frankable by the private company under s 109RC of ITAA 1936).

The Tax Office’s U-Turn

The Draft Ruling is a major U-turn by the Tax Office from their previous (and long standing) view that s 109J could exclude certain payments by a private company arising because of matrimonial property proceedings from the operation of Div 7A.

In particular, the Tax Office’s current view is inconsistent with many private binding rulings on s 109J (eg, PBR 1011434884971, PBR 1011437352778, PBR 1011482127581, PBR 1011509693406 and many others). The Draft Ruling is also implicitly inconsistent with previous Tax Office public opinions on s 109J (ATO ID 2004/462). In ATO ID 2004/462, the Tax Office states that s 109J requires a payment of money (rather than a transfer of property) and that the private company be a party to the family law proceedings.

Section 109J: what does it actually require?

Section 109J states that:

“A private company is not taken under section 109C to pay a dividend because of the payment of an amount to the extent that the payment:

(a)   discharges an obligation of the private company to pay money to the entity; and

(b)   is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm’s length.” (emphasis added)

Paragraph 88 of the Draft Ruling states that in the Tax Office’s view, it is not sufficient to test what ought to be paid to discharge the relevant obligation. What is also required is a contractual foundation test of what the relevant obligation would be, had the parties been dealing at arm’s length immediately prior to the subject obligation being incurred by the company. That is despite the words of s 109J(b) appearing more concerned with the amount of the payment rather than the obligation.

The Tax Office argues that comments by Lingren J in Di Lorenzo Ceramics Pty Ltd & Anor v FC of T 2007 ATC 4662 and the policy intent of s 109J (ie, avoiding an under market transfer of value out of a private company being a disguised dividend via a “soft loan” for instance) support the Draft Ruling on this point. In our view, the reference in para 89 of the Draft Ruling takes the comments of Lingren J out of context. The policy issue is dealt with later in this article.

The “Alternative Postulate”

Assuming that the Draft Ruling is correct, s 109J(b) therefore requires a comparison with an alternative hypothesis in which the private company is dealing with the “payee” at arm’s length.

Given the recent amendments to Pt IVA, most practitioners would be weary of the words “alternative postulate”. Practitioners will recall that with the recent t IVA changes, the “alternative postulate” test was modified to include certain unrealistic assumptions.

In the Draft Ruling, a similar approach is taken. However, instead of having to work with unrealistic assumptions, the Tax Office simply concludes that in the context of a private company and family law proceedings, the amount of the “arm’s length” obligation will always be zero. This is because “the Commissioner considers there is no identifiable circumstance under which a private company might make a gratuitous appropriation of profits to a non-shareholder in discharge of an obligation in an arm’s length dealing as required by the test in paragraph 109J(b) of the ITAA 1936”. (emphasis added)

Never in the best interests of the company?

It is difficult to see how a private company can never deal with its shareholders (or associates) on an arm’s length basis merely because family law proceedings are involved. By adopting this view, the Tax Office appear to be confusing the concept of “dealing at arm’s length” with the concept of parties “being at arm’s length”.

In our experience, family law proceedings can have a devastating effect on the financial health of a private company. For this reason, it is usually in a private company’s best interests to achieve an out of court settlement (and avoid litigation) or settle family law proceedings by participating in a binding financial agreement. As a blanket rule, it is difficult to see how there could be “no identifiable circumstance” where incurring a family law obligation is not in the commercial best interests of a private company.

Interestingly, the Tax Office cites s 109RC and the explanatory memorandum to the Bill introducing s 109RC to justify this view that s 109J is not intended to apply in such circumstances. However, can the explanatory memorandum to s 109RC really influence the clear words of s 109J? Such an approach seems at odds with the usual principles of statutory interpretation (in particular, the golden rule of giving statutes their clear meaning unless that meaning gives rise to an absurd result). Below is an example of the tax effect of the non-application of s 109J, based on the Draft Ruling.

Example – Section 109J: Before and after the Draft Ruling
1. Bob sets up B&B Pty Ltd (BBCo) in 1990 as its only shareholder and is married to Betty.
2. BBCo’s business is worth $2m.
3. Bob & Betty are now going through a divorce and want to finalise their property settlement (pursuant to s 79 of the Family Law Act 1975) so that:
a) Bob is to keep the Business;
b) BBCo is itself legally obliged by court order or a valid binding financial agreement to pay $1m to Betty (the Obligation);
4. Prior to the Draft Ruling, it is likely that s 109J could potentially apply to the Obligation. If so, the payment of that Obligation (the Payment) would have no Div 7A consequences.
5. Applying the Tax Office’s view in the Draft Ruling, s 109J will not apply to the Payment. This is because the Obligation would be non-existent if the parties were dealing at arm’s length. Thus, Betty is deemed to receive a deemed dividend of $1m under Div 7A as Betty is clearly an associate of Bob, being the Company’s only shareholder.
6. BBCo may be able to frank the dividend under s 109RC (if BBCo has sufficient franking credits and has a franking percentage of 100%). However, Betty will still be required to pay “top-up tax”.
7. Assuming that Betty has no other income for the year (ie, her assessable income is $1m), Betty will be required to pay $138,547 in tax (ie, $438,547 less $300,000).


When does the Draft Ruling apply from?

The Tax Office proposes that the final Ruling (once issued) will apply both before and after its date of issue. The Commissioner proposes not to undertake active compliance activities (eg, audits) to apply that view in respect of any family law property orders made before the date the final Ruling is issued. The Draft Ruling nevertheless states the Commissioner’s view and the Commissioner will apply that view where he is required to do so. We note that the Tax Office has already applied this view in some very recent private binding rulings (see, for instance, PBR 1012507588469).

The Benefit of a Private Ruling

Due to the protection afforded by obtaining a private ruling binding, affected taxpayers who have obtained favourable private rulings on the subject can rely on those private rulings. More generally, this experience serves as a great example of the benefits in seeking a private binding ruling and the certainty that a taxpayer can achieve by doing so (particularly where the Tax Office changes its interpretation of the law).


We consider that the Commissioner’s view of s 109J(b) is flawed. The Draft Ruling should be withdrawn and rewritten so that it is consistent with the actual words of the section, the previous Tax Office stance and in light of the issues raised in this article.

The Tax Office invites comments on the Draft Ruling and provides the relevant contact details at Appendix 3 of the Draft Ruling. We encourage readers with like opinions to join us in doing so. In the interim, extreme care needs to be taken to structure family law settlements in light of this new risk.

**** First Published in CCH’s Australian Income Tax Tracker – Issue 11 November 2013

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Martin Checketts
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