TD 2008/1: Income tax: if a private company provides trade credit to a shareholder (or their associate) on the usual terms it gives to parties at arm's length, will a failure by the shareholder (or their associate) to repay the amount within the agreed payment term prevent section 109M of the Income Tax Assessment Act 1936 from applying?
 

Please note that the PDF version is the authorised version of this ruling.

Ruling

1. No. A failure of a shareholder (or their associate) to repay the trade debt within the agreed payment term will not prevent section 109M of the Income Tax Assessment Act 1936 (ITAA 1936)¹ applying, provided the private company deals with the failure to repay in the same manner in which it deals with defaults on similar loans made to parties at arm's length. If the amount is fully repaid before the company's lodgment day² (or by the end of the income year for the 2003-04³ and earlier income years), section 109M does not need to be considered.

Date of effect

2. This Determination applies to years of income commencing both before and after its date of issue. However, the Determination does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10).

Example 1

3. During the 2006-07 income year a private company in the ordinary course of business sells goods on a credit basis to both shareholders and arm's length parties. The terms and conditions set out in the written credit agreements are similar, with the payment term being 60 days.

4. The private company's lodgment day was 28 December 2007 and at that time a shareholder, Gavin, owed the company $2,500 for goods purchased on 31 March 2007. The company followed its normal debt collection policies and procedures in respect of the shareholder's failure to repay the trade debt on time.

5. Section 109M can apply because the credit is provided to Gavin in the ordinary course of the company's business and on the usual terms on which the company makes similar loans to parties at arm's length.

Example 2

6. The same facts as in Example 1 except the private company did not follow its usual debt collection policies and procedures. Furthermore, it had a history of allowing Gavin extra time to pay his trade debts, without following the policies and procedures it applies in respect of trade debtors at arm's length.

7. Section 109M does not apply because the credit is not provided to Gavin on the usual terms on which the company makes similar loans to parties at arm's length.

Example 3

8. A private company produces widgets which are sold on a credit basis to the trustees of the A Discretionary Trust and the B Discretionary Trust. The widgets are materials used in the production of goods for sale to the general public. The shareholders of the private company are beneficiaries of both trusts and as a result the trustees of the trusts are associates of the shareholders.

9. The widgets are sold on similar terms and price to those sold by similar manufacturers to arm's length customers. At 30 June 2007 both trustees owed the private company for widgets purchased during the 2006-07 income year. By the company's lodgment day for 2006-07 tax return, the trustee of the A Discretionary Trust had fully repaid the trade debt outstanding at 30 June 2007, but the trustee of the B Discretionary Trust still owed an amount in respect of 2006-07 purchases.

10. Section 109M does not need to be considered in relation to the provision of trade credit to the A Discretionary Trust in the 2006-07 income year because it was fully repaid before the company's lodgment day for that income year.

11. Although the trade credit is provided to the trustee of the B Discretionary Trust in the ordinary course of the company's business, section 109M does not apply because the company does not make similar loans to parties at arm's length, that is, entities that are neither shareholders nor associates of such shareholders of the company.

Commissioner of Taxation

16 January 2008

Appendix 1 - Explanation

Explanation

12. The provision of trade credit is a loan for Division 7A of Part III (Division 7A) purposes because it falls within the definition of 'loan' in subsection 109D(3). A 'loan' includes:

·

  an advance of money;

·

  a provision of credit or any other form of financial accommodation;

·

  a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and

·

  a transaction (whatever its terms or form) which in substance effects a loan of money.

13. If the private company enters into commercial transactions, dealings and exchanges with entities (including a shareholder, or an associate of a shareholder of the private company), on a credit basis then there is a loan for the purposes of Division 7A.

14. Section 109M is one of the provisions in Subdivision D of Division 7A which describes the loans that are not treated as dividends under section 109D. Section 109M provides:

A private company is not taken under section 109D to pay a dividend because of a loan made:

(a)

  in the ordinary course of the private company's business; and

(b)

  on the usual terms on which the private company makes similar loans to parties at arm's length.

 

15. Subdivision D only needs to be considered if the loan is not fully repaid before lodgment day for loans made in the 2004-05 or a later year of income and by the end of the year of income for loans made in the 2003-04⁴ and earlier years of income.⁵ Therefore, if the trade debt is fully repaid before the relevant day for the income year then section 109M will have no application.

16. Paragraph 109M(a) requires the loan to have been made in the ordinary course of carrying on the private company's business. Whether it does depends on the circumstances of the case.

17. Paragraph 109M(b) requires the loan to have been made on the usual terms on which the private company makes similar loans to parties at arm's length. The parties at arm's length for paragraph 109M(b) purposes can comprise a segment or section of the client or customer base. For a loan to be similar there is no requirement that the loan be identical. However, the loan should be similar in terms of both documentation and conditions.

18. The usual terms are those terms under which the private company usually contracts. The fact that a private company may be engaging in credit transactions for the first time will not of itself prevent those transactions from being made on the usual terms under which the company provides credit. The policy and procedures may have been established before entering into the contract or the terms of the contract may establish the usual terms. Whether or not the initial provision of credit establishes the usual terms will be evidenced by the terms upon which subsequent contracts are entered into.

19. If loans are only made to parties not at arm's length (even though such loans may be made on arm's length terms), paragraph 109M(b) is not satisfied.

20. In paragraph 109M(b) the phrase 'at arm's length' is used. There is no reference to 'dealing at arm's length' in that paragraph. The meaning of 'at arm's length' is explained in the following paragraphs from Taxation Ruling TR 2006/7:

189. The phrase 'at arm's length' has been considered in many courts and used in various legislative contexts. As explained by Davies J in Re Hains (deceased); Barnsdall v. Federal Commissioner of Taxation ⁶ (Barnsdall) the term 'at arm's length' was developed in the law with respect to transactions between persons, one of whom, such as a trustee or a solicitor, is in a position of special influence with respect to the other, a beneficiary or client. His Honour referred to the classic statement of principles found in the speech of Lord O'Hagan in Macpherson v. Watt. ⁷

 

190. Davies J pointed out, however, that such cases are of little assistance in the interpretation of statutes which are concerned with taxation.⁸

 

191. His Honour then went on to set out the interpretation of the phrase 'not at arm's length' that was provided in Australian Trade Commission v. WA Meat Exports Pty Ltd. ⁹ This is the leading case on the meaning of the phrase 'not at arm's length' in the definition of 'prescribed associate' in subsection 4(8) of the Export Market Development Grants Act 1974. The Federal Court decided in that case that the ordinary meaning of the phrase applies. After quoting legal dictionaries in order to ascertain the ordinary meaning of 'arm's length',¹⁰ the Federal Court reached the conclusion that the ordinary meaning of the phrase 'not at arm's length' is the circumstance where one party 'has the ability to exert personal influence or control over the other'.¹¹

 

21. Whether parties are at arm's length requires consideration of any connection between the parties and of all the relevant circumstances. In the context of Division 7A private companies, their shareholders and associates of such shareholders have sufficient connection to not be at arm's length.

22. For section 109M purposes it is not relevant whether a trade debt is paid outside of payment terms such as 30, 60 or 90 day terms so long as it can be accepted that the credit was provided in the ordinary course of the private company's business and is similar to the usual arrangements made by the company with parties at arm's length.

23. If the private company does not deal with a failure to repay on time by a shareholder (or their associate) in the same manner in which it deals with defaults of similar loans made to parties at arm's length, then this casts doubt on whether the trade credit was provided on the usual terms on which the private company makes similar loans to parties at arm's length.

Footnotes

[1] 
All subsequent legislative references in this Determination are to the ITAA 1936 unless otherwise indicated.
 

[2] 
As defined in subsection 109D(6), the lodgment day for a private company's year of income is the earlier of:

(a)

  the due date for lodgment of the private company's return of income for the year of income; and

(b)

  the date of lodgment of the private company's return of income for the year of income.

[3] 
Law Administration Practice Statement PS LA 2005/3 (GA) includes an administrative concession for the 2003-04 income year which allows taxpayers in specified circumstances up until the company's lodgment day to repay a loan.
 

[4] 
Law Administration Practice Statement PS LA 2005/3 (GA) includes an administrative concession for the 2003-04 income year which allows taxpayers in specified circumstances up until the company's lodgment day to repay a loan.
 

[5] 
Subsection 109D(1).
 

[6] 
(1988) 81 ALR 173 at 176.
 

[7] 
[1877] 3 App Cas 254 at 266; (1988) 81 ALR 173 at 176.
 

[8] 
(1988) 81 ALR 173 at 176. See also Re CHK Engineering Pty Ltd and Australian Trade Commission (1997) 45 ALD 797 at 797.
 

[9] 
(1987) 75 ALR 287; (1988) 81 ALR 173 at 176.
 

[10] 
(1987) 75 ALR 287 at 291.
 

[11] 
(1987) 75 ALR 287 at 291.
 

Previous Draft:

TD 2007/D17

References

ATO references: 
NO  2007/7257

ISSN: 1038-8982

Related Rulings/Determinations: 
TR 2006/7 
TR 2006/10

Subject References: 
deemed dividends 
disguised dividends 
dividends

Legislative References: 
ITAA 1936 Pt III Div 7A 
ITAA 1936 109D 
ITAA 1936 109D(1) 
ITAA 1936 109D(3) 
ITAA 1936 109D(6) 
ITAA 1936 Pt III Div 7A Subdiv D 
ITAA 1936 109M 
ITAA 1936 109M(a) 
ITAA 1936 109M(b) 
TAA 1953 
Export Market Development Grants Act 1974 4(8)

Case References: 
Australian Trade Commission v. WA Meat Exports Pty Ltd 
(1987) 75 ALR 287

Macpherson v. Watt 
[1877] 3 App Cas 254

Re CHK Engineering Pty Ltd and Australian Trade Commission 
(1997) 45 ALD 797

Re Hains (deceased); Barnsdall v. Federal Commissioner of Taxation 
(1988) 81 ALR 173 
88 ATC 4565 
19 ATR 1352

Other References 
PS LA 2005/3 (GA)