Division 7A: meaning of 'net income' in section 109XA

Is the accounting income of the trust estate its 'net income' for the purposes of subsection 109XA(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Yes. The accounting income of the trust estate determined by the trustee in accordance with the trust deed and applicable accounting standards is the 'net income' of the trust estate for the purposes of subsection 109XA(1) of the ITAA 1936.

ABC Pty Ltd a private company is presently entitled to $1,000 of accounting income of the XYZ trust estate determined by the trustee in accordance with the trust deed and applicable accounting standards that remains unpaid.

The trustee of the XYZ trust estate creates a present entitlement to an unrealised gain to the taxpayer a shareholder of ABC Pty Ltd of $500.

The trustee makes a payment of $200 to the taxpayer reducing the taxpayer's present entitlement to the unrealised gain.

The whole of the amount to which ABC Pty Ltd is presently entitled is not paid to the private company before the earlier of the due date for lodgment and the date of lodgment of the trustee's income tax return for the XYZ trust estate for the income year.

Subdivision EA of Division 7A of Part III of the ITAA 1936 (Subdivision EA) came into effect from 12 December 2002 and replaced section 109UB of the ITAA 1936. The amendments in subdivision EA generally apply to payments or loans made, or debts forgiven on or after 12 December 2002.

Broadly speaking, the new rules in Subdivision EA deem certain payments, loans, or forgiven debts by a trustee of a trust estate to a shareholder (or their associate) of a private company to be included in their assessable income as if it were a dividend where the private company is presently entitled to an amount from the net income of the trust estate and that amount has not been fully paid out.

Under subsection 109XA(1) of the ITAA 1936 the new rules apply to a payment: • a trustee of a trust estate makes to a shareholder (or their associate) of a private company • that discharges or reduces a present entitlement of the shareholder or associate which is attributable to an unrealised gain

where the private company is presently entitled to an amount from the 'net income' of the trust estate: • at the time of the payment and the whole of that amount has not been paid to the company before the earlier of the due date for lodgment and the date of lodgment of the trustee's income tax return for the trust for the income year, or • for payments on or after 19 February 2004, after the time of the payment but before the earlier of the due date for lodgment and the date of lodgment of the trustee's income tax return for the trust for the income year and the whole of that amount has not been paid to the company before the earlier of those dates.

The payment and the amount of the deemed dividend (if any) is subject to the rules in Subdivision EA contained in other provisions in section 109XA of the ITAA 1936 and in section 109XB of the ITAA 1936. These rules include the application of the remainder of Division 7A of Part III of the ITAA 1936 as modified under section 109XC of the ITAA 1936.

'Net income' in subsection 109XA(1) of the ITAA 1936 is not expressly defined for the purposes of Subdivision EA or Division 7A of Part III of the ITAA 1936 and therefore the phrase adopts its ordinary meaning as conveyed by the words of the phrase having regard to its context and the purpose or object of the legislation ( CIC Insurance Ltd v. Bankstown Football Club Ltd (1997) 187 CLR 384; Commissioner of Taxation v. Linter Textiles Australia Ltd (in liq) (2003) 129 FCR 42); 2003 ATC 4458; (2003) 52 ATR 502).

Under paragraph 15AB(1)(a) of the Acts Interpretation Act 1901 consideration may be given to extrinsic material such as the Explanatory Memorandum to the legislation introducing Subdivision EA to confirm the ordinary meaning of the phrase.

The literal meaning of the phrase 'net income' is indicated by the definition of its terms in The Macquarie Dictionary , 2003, rev. 3rd edn, The Macquarie Library, NSW in the relevant context: net: exclusive of deductions, ultimate; final; after all calculations have been made, or all additions and subtractions have had their effect; net income, profits, or the like. income: the returns that come in periodically, especially annually, from one's work, property, business, etc.; revenue; receipts; something that comes in.

net: | exclusive of deductions, ultimate; final; after all calculations have been made, or all additions and subtractions have had their effect; net income, profits, or the like.

income: | the returns that come in periodically, especially annually, from one's work, property, business, etc.; revenue; receipts; something that comes in.

Section 109XA and Subdivision EA are embodied in Division 7A of Part III of the ITAA 1936 which seeks to treat private company distributions of profits in the form of payments, loans, or forgiven debts as deemed dividends. Under Subdivision EA and the remainder of Division 7A of Part III of the ITAA 1936 the amount of any deemed dividend is limited to the distributable surplus of the private company as determined from the private company's accounting records under section 109Y of the ITAA 1936.

Therefore the ordinary meaning of the phrase 'net income' in the context of subsection 109XA(1) of the ITAA 1936 is the accounting income or the income less expenses of the trust for the income year as determined by the trustee in accordance with the trust deed and applicable accounting standards.

Confirmation is provided in the Explanatory Memorandum to the Tax Laws Amendment (2004 Measures No. 1) Act 2004 in the examples of the operation of section 109XA of the ITAA 1936. In all the examples it is stated that the private company has a present entitlement to an amount of 'accounting income' of a trust estate that remains unrepaid.

In the circumstances here, the taxpayer is a shareholder of a private company ABC Pty Ltd which is presently entitled to an amount from the accounting income of the XYZ trust estate as determined by the trustee in accordance with the trust deed and applicable accounting standards.

Therefore at the time the trustee of XYZ trust estate makes a payment of $200 reducing the taxpayer's present entitlement to an unrealised gain from the trust estate, a private company of which the taxpayer is a shareholder is presently entitled to an amount from the net income of the trust estate for the purposes of subsection 109XA(1) of the ITAA 1936.

The whole of that amount to which ABC Pty Ltd is presently entitled is not paid to the private company before the earlier of the due date for lodgment and the date of lodgment of the trustee's income tax return for the trust for the income year.

Therefore by virtue of subsection 109XA(1) of the ITAA 1936 the payment of $200 is subject to Subdivision EA and the modified application of the remainder of Division 7A of Part III the ITAA 1936. With the result that the payment may be a deemed dividend included in the assessable income of the taxpayer for the income year subject to the distributable surplus of the private company.