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?

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 day [2] (or by the end of the income year for the 2003-04 [3] and earlier income years), section 109M does not need to be considered.

When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the final Determination will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the final Ruling (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10).

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 the same, with the payment term being 60 days.

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.

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.

The same facts as in Example 2 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.

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.

A private company produces widgets which are sold on a credit basis to the trustees of the ABC Discretionary Trust and DEF 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.

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 ABC Discretionary Trust had fully repaid the trade debt outstanding at 30 June 2007, but the trustee of the DEF Discretionary Trust still owed an amount in respect of 2006-07 purchases.

Section 109M does not need to be considered in relation to the ABC Discretionary Trust trade debt because it was fully repaid before lodgment day.

Although the loan to the trustee of the DEF Discretionary Trust is made 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.

The provision of trade credit is a loan for 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.

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.

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 2003-04 [4] 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.

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.

Paragraph 109M(b) requires consideration of whether there are, or have been, similar loans made to parties at arm's length. 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.

In paragraph 109M(b) the phrase 'at arm's length' is used. There is no reference to 'dealing at arm's length' in the 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]

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]

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.

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.

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.

We invite you to comment on this draft Taxation Determination. Please forward your comments to the contact officer by the due date. (Note: the Tax Office prepares a compendium of comments for the consideration of the relevant Rulings Panel or relevant Tax officers. The Tax Office may use a version (names and identifying information removed) of the compendium in providing responses to persons providing comments. Please advise if you do not want your comments included in the latter version of the compendium.) Due date: 16 November 2007 Contact officer details have been removed following publication of the final ruling.