In a draft Taxation Ruling (TR 2013/D6) issued yesterday (13 November 2013), the ATO reversed what was previously a favourable view to taxpayers regarding Family Court-ordered cash payments made by family companies to non-shareholder spouses in matrimonial proceedings.
Previously, the ATO has taken the view that if, in matrimonial proceedings, the Family Court ordered a cash payment to be made by a family company to a spouse who was not a shareholder in the company (the other spouse being a shareholder), the only basis for assessment was under Division 7A as a payment to an associate of a shareholder.
However the ATO also previously accepted that, in such cases, section 109J of the Income Tax Assessment Act 1936 excluded the payment from being assessed to the spouse as a deemed dividend under Division 7A.
Section 109J provides an exception to payments for the purposes of Division 7A where the company “discharges an obligation…to pay money”. The ATO has, to date, accepted that the order of the Family Court was an “obligation” of the company to pay that amount of money.
Under the proposed new Ruling, that will no longer be the case. Consequently the spouse who receives the money will be treated for tax purposes as having received a deemed dividend from the company under Division 7A.
The draft Ruling acknowledges that this view differs from the view expressed in prior rulings and states:
“…the Commissioner proposes not to undertake active compliance activities so as to apply that view in respect of any such orders made before the date the final Ruling is issued.”
Put shortly, the ATO will not set out to pursue assessment of spouses who have received such payments in the past. However if such a payment comes to the ATO’s attention in an audit or other inquiry within the permitted period for amending assessments, unless the taxpayer had previously obtained a private ruling favourable to the payment, an adverse assessment may be made.
Section 109J and the new ATO reasoning
To qualify for the exception under section 109J, paragraph 109J(b) provides that the amount paid by the company must be “no more than would have been required to discharge the obligation had the private company and [the spouse] been dealing with each other at arm’s length.”
In other words, paragraph (b) prevents the exception being used to inflate the amount of an obligation in a commercial dealing.
The ATO’s new reasoning is based on the view that paragraph (b) implies that, before any obligation can qualify for exception under section 109J, it must be measurable by reference to a commercial dealing which is capable of being tested by the “arm’s-length” tests which apply to such dealings. This, the ATO concludes, involves identifying “an alternative hypothesis” in which “the company is engaged in a ‘dealing’ and pursuing its own best interests”.
This leads the ATO to conclude that in the case of a Court order resulting in a payment obligation, it is necessary to identify an alternative obligation that “would have arisen had the parties been ‘dealing with each other at arm’s length’ ”.
Based on this extraordinary piece of logic, the draft Ruling successfully completes the administrative back-flip by going on to conclude that, because a company would not make such a payment in pursuit of its own interests on any arm’s-length basis, it follows that an order made by the Family Court to make such a payment has no value in arm’s-length terms and therefore cannot fall within the exclusions contemplated by section 109J.