Income tax: what is a 'present legal obligation' of a private company for the purposes of subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936?

A 'present legal obligation' of a private company for the purposes of subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936 [1] is an immediate obligation binding at law, whether payable and enforceable presently or at a future time. Future provisions and contingencies are not included in the distributable surplus calculation under section 109Y unless they are one of the accounting provisions specifically set out in, or prescribed under, subparagraph (b) of the definition of 'net assets' in subsection 109Y(2).

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 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).

Z Coy Pty Ltd (Z Coy) operates a small financial services business and as at 30 May 2007 receives a quarterly rates demand from the local council in respect of its business premises. The demand is due for payment by 21 June 2007 but Z Coy does not make payment for a further 2 weeks. The amount of the rates demand is an immediate obligation binding at law and presently enforceable. It is therefore a present legal obligation for the purposes of paragraph 109Y(2)(a).

X Coy Pty Ltd operates a small mixed goods retail business and at 20 June 2007 receives an electricity bill for supply in the preceding quarter which is not due for payment until 11 July 2007. The amount of the electricity bill is an immediate obligation binding at law and enforceable at a future time. It is therefore a present legal obligation for the purposes of paragraph 109Y(2)(a).

Y Coy Pty Ltd (Y Coy) operates a small lawn mower retail business and provides free repairs for selected customers for an additional 2 years after the manufacturer's warranty period expires. Y Coy does not advertise this service but it is known in the community that free repairs may be provided outside of the warranty period. Y Coy expects to provide 20 out of warranty repairs at a cost of approximately $5,000 as at 30 June 2007 in respect of completed sales as at that date. Y Coy takes $5,000 up as a 'provision for out of warranty repairs' when compiling its annual reports for the reporting period ending 30 June 2007. The provision taken up by Y Coy is not enforceable by legal action either presently or in the future and is therefore not a present legal obligation for the purposes of paragraph 109Y(2)(a).

M Coy Pty Ltd (M Coy) operates a small advertising agency and in most income years having regard to staff performance and profitability determines to pay bonuses to its employees at 30 June. The bonuses are payable during the next 6 months and are entirely at the volition of M Coy and do not form part of the employment contract between M Coy and its employees. At 30 June 2007, M Coy determines to pay bonuses totalling $50,000 and in its financial reports for the reporting period ending 30 June 2007, takes this amount up as a 'provision for employee bonuses'. The provision taken up by M Coy is not enforceable by legal action either presently or in the future and therefore does not qualify as a present legal obligation within the meaning of paragraph 109Y(2)(a).

Division 7A treats: (i) certain payments and loans made by a private company to a shareholder or a shareholder's associate; and (ii) certain debts owed by a shareholder or a shareholder's associate forgiven by the private company, as unfranked dividends taken to have been paid by the private company. Those unfranked dividends are included in the assessable income of the shareholder or associate under section 44.

The total amount taken to have been paid as dividends under Division 7A is limited to the amount of a private company's 'distributable surplus' calculated in accordance with section 109Y. Distributable surplus in effect limits the total amount of dividends taken to be included in assessable income in the same way as 'profits' limit how much of an actual distribution is included in assessable income. [2]

The formula for calculating a private company's distributable surplus is contained in subsection 109Y(2), being 'Net assets - non-commercial loans - paid-up share value - repayments of non-commercial loans' (the 'distributable surplus formula'). A key element in the distributable surplus formula is the private company's net assets. Net assets are defined as follows: the amount (if any), at the end of the company's year of income, by which the company's assets (according to the company's accounting records) exceed the sum of: (a) the present legal obligations of the company to persons other than the company; and (b) the following provisions (according to the company's accounting records): (i) provisions for depreciation; (ii) provisions for annual leave and long service leave; (iii) provisions for amortisation of intellectual property and trademarks; (iv) other provisions prescribed under regulation made for the purposes of this subparagraph. If the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate.

In the context of section 109Y, the phrase 'present legal obligation' is to be interpreted in accordance with its legal meaning. At law, a 'legal obligation' is an obligation, right or duty arising from contract, statute or the operation of general law which is enforceable by legal action. In Brett v. Barr Smith (1919) 26 CLR 87 at 97 Higgins J stated: 'Obligation' is a technical term of law, with a clear definite meaning; and statutes which make law must prima facie be treated as using technical words in their technical sense. There is no ground here for treating 'obligation' as meaning moral obligation, or social obligation, or business obligation (in the sense of commercial pressure or expediency), or anything but legal obligation. The test is: Is there any legal sanction - would an action lie (if there were no sec 54) against the mortgagors for failure to pay the income tax? 'Obligation' involves binding; and there is nothing here to bind the mortgagors to pay the amount of tax.

Although the phrase 'present legal obligation' takes its legal meaning, current Australian accounting standards and concepts would produce a similar result. The AASB Framework for the preparation and presentation of financial statements defines a liability as 'a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits'. [3] At paragraphs 60 to 63 of The Framework it is emphasised that an essential characteristic of a liability is that the entity has a present obligation , being a duty or responsibility to act or perform in a certain way. It is noted that obligations may be legally enforceable as a consequence of a binding contract or a statutory requirement, or arise from normal business practice and custom.

AASB Accounting Standard 137 concerns Provisions, contingent liabilities and contingent assets (AASB 137). [4] That standard does not apply where another standard deals with a specific type of provision, which is the case for the three types of provisions listed in paragraph 109Y(2)(b). Paragraph 10 of AASB 137 defines a 'provision' as 'a liability of uncertain timing or event'. [5]

Paragraph 10 of AASB 137 also defines a 'legal obligation' consistently with its technical legal meaning as 'an obligation that derives from: (a) contract (through its explicit or implicit terms); (b) legislation; or (c) other operation of law'. [6] The application of the definition of 'legal obligation' in AASB 137 to subsection 109Y(2) coincides with the technical legal meaning of the phrase discussed above, that is an obligation, right or duty arising from contract, statute or the operation of general law which is enforceable by legal action immediately or in the future. Legal obligations within the technical legal meaning of the phrase would also be 'legal obligations' under the definition in paragraph 10 of AASB 137.

Paragraph 14 of AASB 137 provides that a provision shall be recognised when, inter alia, an entity has a present obligation (legal or constructive) as a result of a past event. Paragraph 17 provides that a past event that leads to a present obligation is an obliging event: For an event to be an obliging event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the case only: (a) where the settlement of the obligation can be enforced by law; or (b) in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will discharge the obligation. [7]

Under the current AASB accounting standards, a present obligation (of a legal nature) includes obligations that are legally enforceable, although they may not be immediately enforceable. For example, a dividend which has been declared but for which the stipulated date for payment has not yet arisen, or a trade invoice which has been rendered but for which the stipulated date for payment has not yet arisen. [8]

Therefore, as a practical matter a present obligation of a legal nature under AASB accounting standards would also be a present legal obligation for the purposes of the distributable surplus formula in section 109Y. However, as already stated the test is one of jurisprudence rather than accounting treatment.

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: 22 June 2007 Contact officer details have been removed following publication of the final ruling.