Honest mistake in not documenting private company loans

The Administrative Appeals Tribunal (AAT) has exercised the discretion to disregard the operation of Div 7A of the Income Tax Assessment Act 1936 (ITAA 1936) on the grounds there was an honest mistake in not properly documenting loans by a private company to a shareholder.

Background

The taxpayer was a shareholder and director of a building company that carried on business in suburban Sydney. In the 2005 income year, the company transferred money to the taxpayer on a number of occasions. The taxpayer said that he instructed his accountant to treat each transfer as a loan. However, the money transferred to the taxpayer was recorded in the company's accounts and 2005 tax return as "trade creditors". The accounts and tax return were prepared on the basis of cheque butts and bank statements provided by the taxpayer.

Sometime after the 2005 tax return was lodged in June 2006, the taxpayer's accountant arranged for the taxpayer to sign a simple loan agreement covering past and future payments to the taxpayer. The agreement, which was not dated, required the taxpayer to pay interest at the benchmark interest rate published by the ATO. Normally, the taxpayer's accountant would prepare a loan agreement as soon as the need for a written agreement is identified (although this might not be until after the end of the relevant income year). The company also transferred various amounts to the taxpayer in the 2006 and 2007 income years. These amounts were recorded as loans in the company's accounts.

The Commissioner applied Div 7A of the ITAA 1936 to treat the payments made in the 2005, 2006 and 2007 income years as assessable dividends. As regards the 2005 payments, the Commissioner rejected the taxpayer's contention that the payments should be treated as loans (and therefore argued that s 109C applied). As regards the 2006 and 2007 payments, although the Commissioner accepted that the payments were loans, he applied s 109D because the loans were not properly documented due to the loan agreement not specifying the term of the loans.

The taxpayer argued that the Commissioner should have exercised his discretion under s 109RB to effectively ignore the application of Div 7A because of an "honest mistake" or an "inadvertent omission".

Decision

As regards the 2005 payments, the AAT was not satisfied that they were loans. As a result, the taxpayer accepted that the s 109RB discretion could not be exercised in relation to those payments.

As regards the 2006 and 2007 payments, the AAT decided that the s 109RB discretion should be exercised as there had been an honest mistake in failing to document the loans properly. In reaching this conclusion, the AAT had to consider the various matters listed in s 109RB(3):

• the circumstances that led to the mistake or omission – the AAT considered that these were benign and weighed neither in favour of nor against exercising the discretion;

• what corrective action was taken and when – no action was taken to correct the shortcomings in the loan agreement, which weighed against exercising the discretion;

• whether Div 7A had operated previously – it had not, weighing in favour of exercising the discretion;

• any other relevant matters – the AAT considered that the extent and timing of repayment of the loans was a relevant matter. This weighed in favour of exercising the discretion because, although no one seemed to know at any one time how much of the loans had been paid off, the evidence showed that during the 2007 income year the taxpayer paid $150,000 to the company, whereas by 30 June 2006 he had only borrowed $139,189. This meant that the minimum annual repayments had been made.

As regards an administrative penalty in relation to the 2005 income year, the AAT concluded that the taxpayer and his accountant had failed to take reasonable care, but they had not been reckless. Accordingly, the appropriate penalty level was 25% of the shortfall amount.

Re Building Company Owner and FCT [2012] AATA 755, www.austlii.edu.au/au/cases/cth/AATA/2012/755.html.