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If a private company makes a loan in an income year (the original loan) and, in the following income year (and before the relevant lodgment day) puts in place a written loan agreement which amounts to a new loan, does section 109D of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the original loan in the income year in which the original loan is made?

Yes. If a private company makes a loan in an income year (the original loan) and, in the following income year (and before the relevant lodgment day) puts in place a written loan agreement which amounts to a new loan, section 109D of the ITAA 1936 applies to the original loan in the income year in which the original loan is made.

During the 2011-12 income year, a private company (ABC Pty Ltd) made an unsecured loan to an individual taxpayer who was the company's sole shareholder (the "original loan").

In the 2012-13 income year, but before the private company's lodgment day for the 2011-12 income year, the private company puts in place a written loan agreement the elements of which satisfy the criteria in paragraphs 109N(1)(b) of the ITAA 1936 and 109N(1)(c) of the ITAA 1936 (relating to the rate of interest payable on the loan and the term of the loan).

The written agreement evidences a clear intention that ABC Pty Ltd and the individual intend the written agreement to be the making of a new replacement loan. It is agreed that the liability of ABC Pty Ltd, to advance further monies under the new loan agreement, is set-off by the liability of the individual, to repay monies under the original agreement.

All references are to the ITAA 1936 unless otherwise indicated.

The making of a loan by a private company to a shareholder or an associate of the shareholder is treated as the payment of a dividend in the circumstances outlined in section 109D.

However, section 109N prevents a private company from being taken to pay a dividend under section 109D if, before the private company's lodgment day for the year of income (subsection 109N(1)): (a) the agreement that the loan was made under is in writing, (b) the rate of interest payable on the loan for the income year after the year in which the loan is made, equals or exceeds the benchmark interest rate for the year, and (c) the term of the loan does not exceed the maximum term worked out under subsections 109N(3).

Such written agreement is commonly referred to as a 'complying loan agreement' or a 'section 109N loan agreement'.

The making of a complying loan agreement may, as a matter of contract law, either: (a) merely elucidate the terms of an existing loan agreement, (b) vary the terms of an existing loan agreement, or (c) amount to the making of a new loan.

Whether or not, in a particular case, the making of a complying loan agreement amounts to a new loan, or is a variation or mere elucidation of the terms of an existing loan, is a question of fact to be determined by reference to all of the circumstances (ATO ID 2012/61 discusses the consequences of a mere elucidation or variation).

As a matter of ordinary contract law, in order to bring a loan agreement to an end, the borrower's obligation to repay must be discharged. Commonly, this might be achieved by: (I). forgiveness; (II). conventional repayment by the borrower; or (III). mutual set off of: • the borrower's obligations under the original agreement to repay the loan; and • the lender's obligations under a replacement agreement to advance a further loan;

in accordance with the rule in Re Harmony and Montague Tin and Copper Mining Company (1873) LR 8 Ch App 407 (Spargo's Case ). Commonly, the necessary mutual agreement might be found as an express term in the replacement agreement;

If the original loan agreement is not brought to an end, any further agreement intended to be a replacement loan may result in no further loan being made in the sense contemplated by subsection 109D(4). In such cases the further agreement may only amount to a mere variation of the original agreement or alternatively stand as an executory contract.

In cases where a mutual set off is effected, the discharge amounts to a repayment for Division 7A purposes ( FCT v. Rozman 2010 ATC 20-171). In such circumstances, section 109R may apply. Section 109R is intended to prevent shareholders or their associates from avoiding the operation of Division 7A by temporarily repaying a loan.

Broadly, a payment must be disregarded if it is reasonable to conclude, having regard to all of the circumstances, that the borrower intended to obtain a loan or loans from the private company of a total amount similar to or more than the payment (paragraph 109R(2)(a)). Further, a payment must also be disregarded if the new loan or loans are made to the borrower before the borrower makes the payment to the company and it is reasonable to conclude the loan or loans were obtained in order to make the payment (paragraph 109R(2)(b)).

As the written agreement put in place between ABC Pty Ltd and the individual in the 2012-13 income year amounts to a new loan, the original loan is taken to have been repaid at the time the new loan was put in place. However, section 109R operates to disregard the repayment for the purposes of section 109D.

Therefore, as the terms of the original loan were not put in writing before the private company's lodgment day for the 2011-12 income year, and that loan is not taken to be repaid because of section 109R, ABC Pty Ltd is taken to pay a dividend to the individual at the end of the 2011-12 income year (subsection 109D(1)). The amount of the deemed dividend is, subject to section 109Y (relating to the company's distributable surplus).

As the putting in place of the complying loan agreement amounts to a new loan between ABC Pty Ltd and the individual, an amalgamated loan is, for the purposes of Division 7A of Part III, taken to be made in the 2012-13 income year (subsection 109E(3)). Section 109E may apply to the amalgamated loan in the 2013-14 and later income years. Note: In cases where a deemed dividend is the result of an honest mistake or inadvertent omission, taxpayers can apply to the Commissioner to exercise his discretion under section 109RB to either disregard the Division 7A result or allow the deemed dividend to be franked. In making a decision the Commissioner must have regard to the factors listed in subsection 109RB(3) and may make a decision subject to conditions.