ATO says ‘loans’ from company were not loans

ATO successfully penalises professional for no Loan Agreement

Rowntree v FCT [2018] FCA 182 shows that only a legally prepared Loan Agreement satisfies the ATO for related-party loans.

In this case, Justice Raes stated:

‘Bruce Rowntree was an experienced lawyer with extensive academic qualifications in law, finance and taxation. Despite having this impressive resumé, Mr Rowntree engaged, during four years of income, in numerous dealings with companies that he controlled from which he received over $4 million. He did not document any of those dealings as having any particular purpose or character at the time at which he received those large sums of money.’

Lawyer Bruce claimed that he ‘borrowed’ over $4m from his group of private companies.Loan Agreement Division 7A

In contrast, the ATO assessed the money as income – not as a loan. The Court agreed with the ATO. The Court found there had been gross carelessness rather than an intentional disregard of Bruce’s tax obligation

Lawyer Bruce failed to properly record in writing that the money transfers were in fact advances made under a legally enforceable loan agreement or agreements before the subject transactions occurred.

Lawyer Bruce’s arguments

Bruce, as sole director of his companies, argued the money was not income. Rather, Bruce believed that the money was a non-taxable loan principal advances which he had a legal obligation to repay. The Court stated that “he genuinely believed in his own mind that the amounts in question were loans”.

Bruce failed to introduce into evidence a “contemporaneous, corroborating” Loan Agreement.

Instead, Bruce argued that the Loan Agreement did exist but by inference. This was not good enough for the Court. The Court wanted to see the legally prepared Loan Agreement. Bruce even provided financial statements and accounts to show that the accounts recorded the money as a loan. But of course that never works. Journal entries are not loan agreements.

Bruce argued:

“the Corporations Act is largely silent about how a sole director, acting under s 198E(1), should evidence what he causes the company to do. That Act provides that a sole director of such a company may pass a resolution or make a declaration by recording it and signing the record (s 248B). Moreover, a company must keep written financial records that correctly record and explain its transactions, financial position and performance that will enable true and fair financial statements to be prepared and audited (s 286(1)).”

That is a good try, Bruce. But that relates to ASIC requirements. The tax laws require a fully documented Loan Agreement. You could have built a legally prepared Loan Agreement or a Division 7A Loan Agreement on our website in about 12 minutes.

Division 7A argument

Bruce had a read of Div 7A. He argued that s 109N(1)(A) ITAA 1936 required that a compliant Div 7A loan agreement must be recorded in writing “before the lodgment date for the year of income” in which the loan by the company occurred. Bruce argued that a loan agreement may be recorded in writing after the alleged advances had occurred.

I don’t think Bruce is correct here. A Div 7A Loan only applies where it can be shown objectively that the transfers of funds were made under a pre-existing loan. Bruce, read Rowntree and FCT [2016] AATA 420 at 64.

Absent a prior dated loan agreement, there must be contemporaneous evidence (e.g. a Loan Agreement to substantiate the nature of the transfer of funds made). This is trite and obvious law.

Journal entries are not loan agreements

I started practising in taxation law in 1988. Since then the standards for taxpayers has increased. The ATO attacks long-standing practices. The Rowntree case continues that steady march.

Every profession and trade has magic in their bag of tricks. The accountant has the magic of ‘journal entries’ for:

  • liability for debt, loans and loan set-offs
  • payment of employee contributions to reduce FBT issues via a journal to a loan account
  • director/family member salaries booked in the accounts without any physical payment
  • trust distributions not physically paid to the beneficiary
  • unpaid distributions applied to other loan accounts (whether of that beneficiary or others)
  • minimum repayments of Div 7A complying loans made by application of a dividend

Do journal entries evidence a transaction? Usually not. Journal entries merely record what happened. Where the only ‘evidence’ you have is the journal entry – be careful.

How the ATO audits journal entries

Recently in ATO audits they look at the accountant and ask for ‘evidence’ and ‘source documents’ of the transactions relating to the journal.

Many businesses run a treasury role. This is where the family runs all businesses through the same bank account. The business or company may have no bank account itself. (E.g. bank offset accounts, consolidation, managing and reducing overdrafts.)

The ATO looks at ‘arms-length’ normal practice. It is not normal for someone other than yourself to hold your money.

While Loan Agreements prepared after the event are better than nothing, the Loan Agreement should be in place before the money starts moving around. This is what a third party would do. A Loan Agreement signed after the event has less evidentiary value.

Do banks lend money and then later get you to sign a Loan Agreement? Do you move into your commercial lease and then sign the Commercial Lease Agreement?

What can accountants and financial planners learn from this mess?

It is not good enough for your clients to transfer intragroup money during the financial year. And then try and cobble together some correcting journal entries or minutes. Build the Loan Agreement or Div 7A before making any loans.

Do you think that I am applying a high onus of proof? Remember the high onus of proof when challenging an ATO adverse assessment. You have to prove the nature of an intragroup transaction. This requires a contemporaneous Loan Agreement or Division 7A Loan Deed. Minutes, journals and other records are not enough.

Build your Loan Agreement or Div 7A Loan Agreement on our law firm’s website and be protected.

Adj Professor, Dr Brett Davies, CTA, AIAMA, BJuris, LLB, LLM, MBA, SJD
Legal Consolidated Barristers and Solicitors
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