Division 7A Considerations

07 August 2023

This case provides a practical example of the interaction between family law and Division 7A of the Income Tax Assessment Act 1936 (Cth). Interim issues with respect to the payment of tax arose during the hearing of a four-day trial which resulted in the need for an adjournment at expense to the parties and the Court.

The facts

The parties to the proceeding were a husband and wife whose marriage had broken down. The wife was 56 years old and the husband was 60 years old.

The wife had remarried and was employed an administrative assistant earning a salary of ~$72,000.00 per annum. Her husband was employed earning ~$65,000.00 per annum.

The husband had also remarried and was an occupational physician. It was his case that his current wife and his two stepchildren aged 15 and 12 years and his then recently born daughter, aged 2 years, are all economically dependent upon him.

The parties married in 1988. They have two adult children. The parties separated in November 2016 and divorced on 21 March 2018.

During their 28-year marriage, the parties accrued significant assets, mostly in the form of real property. The source of their wealth was a business in which they both worked. It was said that the type of business was that which accountants typically term a mum and dad business.

The business was B Pty Ltd, which manufactured building products. Its corporate structure was created in 2001. The husband was its sole director; with each spouse holding one share. There were no other shareholders.

The husband was involved in the technical side of the business. The wife, who had been a customer service officer, was concerned with accounting and office management. The husband, however, conceded that accounts were largely beyond him.

It was the wife’s case that the administration of the business was in disarray. The husband agreed that the business was not currently tracking well but attributed this to his compromised health and the fact that he had been distracted from it by the family law proceeding.

From its inception the business, after a period of shared frugality between the parties in its early years, seemed to have prospered. It employed staff, including the parties’ children. The parties took advice as to how the business should be structured, particularly how to minimise tax.

The husband became interested in pursuing opportunities as a primary producer. A trust was started which acquired residential properties as investments, which were rented. The wife was its trustee, and she managed its affairs. A farm was also acquired, which was stocked with livestock. At other times it was cropped. It too was owned by the family trust.

The parties opened bank accounts. They had income streams from three sources. From:

  1. rental properties;
  2. the farm; and
  3. primarily their business.

They had living and business expenses. The various entities, which they controlled had obligations to pay loans secured by way of mortgages, which had been taken out to acquire the various properties, including the farm. The business had an overdraft, which was secured against the farm.

On any view, their financial affairs were not without their complexities. Necessarily, whilst their business prospered, the parties and the entities which they controlled incurred liability for tax and were responsible for reporting such obligations to the Deputy Commissioner of the Australian Taxation Office.

In late 2018, in the affidavits which each party filed to commence these proceedings, both the wife and the husband sketched the criticisms they had of the other in respect of the other’s financial mismanagement of their mutual affairs. However, at this early stage, it was their shared position that, given the length of their marriage and their equally significant but disparate contributions, their assets should be divided equally. The wife then changed her position.

Following the four-day final hearing, the Judge opined that there remained serious obstacles to the Court being able to resolve the matter fairly. The chief difficulty being the absence of definitive evidence regarding how much tax was outstanding and how it was referable to each of the parties, both before and after they separated.

Turning then to the positions of the parties, and in summary:

  1. The wife:
    • Characterised the husband as being very difficult to deal with and as a person who did not apply proper financial rigour to his operation of the business after separation, removing funds from it and not accounting to her or the authorities properly for it.
    • Asserted that the husband had only withdrawn funds from the business, whilst attending to only the bare minimum of its other financial obligations, particularly in respect to paying rates, mortgages, and tax, which has led to a significant diminution of the parties’ shared wealth since separation.
    • Contended that she should be allowed a further distribution of assets, in her favour, because of what she characterised as the husband’s waste of matrimonial assets, through financial mismanagement.
    • Suggested that the husband had deliberately run down the business and, once the proceeding had been concluded would resuscitate the business and negate, to his advantage, some loans which it is owed by the parties.
  2. The husband:
    • Asserted that the wife mismanaged the parties’ financial affairs up to separation and that he inherited a mess, which he tried to sort out as best he can. He also characterised the wife as unduly delaying the proceedings because of her grasping nature.
    • Indicated that he did not wish to retain the business considering medical evidence that he would not return to work full time.

The issue of Division 7A loan implications were known to the parties throughout the proceeding. Indeed, a court order was made on 6 August 2021, for the parties to obtain joint single expert advice as to “…any Division 7A Loan implications…” at their joint expense.

In the lead up to an adjourned trial, the wife filed an affidavit of what appeared to be single expert evidence as to the parties’ potential liability in respect of Division 7A. That single expert indicated that the Division 7A loans would crystallise when B Pty Ltd lodged its relevant taxation returns. The quantum / evidence was not clarified with sufficient certainty prior to the listing of the trial following which this judgment was delivered.

Issues which compelled an adjournment

The Trial Judge observed that it was comparatively easy to delineate the major assets of property available to be distributed between the parties and allocate a value to those items. In addition, apart from tax, the parties’ liabilities are also relatively easy to delineate.

However, two significant issues necessitated the Court’s decision to further adjourn the final hearing at the cost of the parties and, ultimately, the taxpayers. Among other things:

  1. The husband had recently adduced evidence of a director’s penalty notice for PAYG withholding amounts, issued by the Deputy Commissioner of Taxation. Attached to that was a statutory demand from the Australian Taxation Office, seeking payment from the husband, as the sole director of B Pty Ltd of an amount of $429,285.61. The wife, quite properly, expressed considerable concern regarding the director’s penalty notice / statutory demand given that she had only became aware of this statutory demand, after she was provided with the husband’s affidavit, electronically filed on the Sunday morning prior to the commencement of the final hearing.
  2. Consideration of the Division 7A Loan issues and how same may impact the balance sheet and thus the parties. An incorrect analysis could result in, among other things, an outcome other than which was proposed / anticipated and then further litigation in the form of an appeal proceeding.

Judicial discussion about Division 7A and tax

Commencing at paragraph [90] of the judgment is important discussion of the relevant principles pertaining to Division 7A. Among other things, it was observed that, difficulties, however, can arise if those loans are not compliant with ATO requirements or there is a lack of precision between legitimate business expenses and monies advanced for an individual’s personal expenditure. In addition, such loans must be repaid to the company in question within 7 years of accrual.

Returning then to the case at hand:

  1. The single expert indicated that the parties had been renumerated approximately equal amounts of around $60,000.00 or less in the period up to 2018. In addition, at this stage, it was his opinion that the parties appeared to have Division 7A debit loan balances. However, he was not able to indicate whether the loans were compliant.
  2. As at 30 June 2018, the single expert estimated the amount owing by the parties to the company as being $379,552.00. Further, in his report, dated 11 April 2022, the single export reported that:
    • He had the company’s accounts up to 28 January 2022. However, he had not performed a review or audit on these records and therefore was not able to assert to either their accuracy or completeness.
    • The loans had now crystallised. In that context, he advised that the parties should engage a tax lawyer to provide advice and assistance with the appropriateness of taking corrective action and an application to the Commissioner.
  3. On 6 April 2022, the single expert had been advised by the husband’s accountant that he (the husband) was liable for income tax of $22,083.38 as at 30 June 2021 and B Pty Ltd owed $346,683.72 as at 1 April 2022. However, the husband also conceded that he had failed to file Business Activity Statements for the business for at least the past 2 quarters and had not made superannuation guarantee payments, either for himself or other employees of the business.

In the foregoing circumstances, the Trial Judge concluded that there was a lack of certainty regarding the overlap between the parties’ potential liability for Division 7A tax and the ongoing company tax, which is the subject of the recently issued statutory demand from the Australian Taxation Office. Whilst the single expert was provided with some financial information to complete an assessment of same, the financial information, with which he had been provided, was, in his view, a mess. In particular, he had doubts about, among other things:

  1. how the receivables / payables, in respect of the business had been constructed; and
  2. in general terms, the non-payment of group tax, by the company, had nothing to do with issues relating to tax potentially to do with the loan amounts taken by each of the parties, to which Division 7A might attach, in the hands of the parties themselves.

What was the outcome?

Noting all these matters, the Court’s major concern was that there was no obvious bottom line as to what the parties, individually and / or collectively, owed to the Australian Taxation Office and what periods it referred to (i.e., before and after separation). Accordingly, it could not ascertain what the parties’ assets and liabilities available to be divided between them as at the date of trial as required by the Family Law Act 1975 (Cth). An adjournment was therefore ordered and for the parties to obtain all relevant evidence.

In that regard, the Court opined that:

  1. Before the Court would be able to approach how the parties’ not inconsiderable assets should be divided, it was incumbent on them to jointly approach the Australian Taxation Office to determine, if possible, what was the exact extent of their liability and the most effective way to pay it.
  1. The Court required detailed submissions from each of them in respect of the taxation issues and how the Court should approach them, particularly in respect of its construction of the relevant balance sheet. Those submissions would be based upon evidence.
  1. Although the exact quantum of the Division 7A liabilities were vague, it seemed improbable that their operation would not be enforced, at some stage, by the Australian Taxation Office (a relevant issue). That said, it was far from clear, given the not inconsiderable period since the parties separated, how the Australian Taxation Office would approach the loans owed by each of the parties concerned to the business.
  1. The decision as to whether both parties should bear responsibility for taxation debts of one party to the marriage should be decided by reference to what was just and equitable. It appeared necessary to determine what is or is not equitable to have some idea of the overall quantum of the relevant debts before turning to its apportionment between the parties concerned.
  1. More detailed evidence regarding the extent of the parties’ joint and individual liabilities to the Australian Taxation Office was necessary before it could be determined in what proportions the parties’ existing assets should be divided.

Contemporaneously with the adjournment, the Court concluded that the husband was likely to continue to access monies in the various accounts of the business, which had been received by the business from its clients, as he had done since separation. Noting the contentious issues, the Court made an injunction preventing same in respect of further loan agreements bearing in mind the timeframe which has been specified for the parties to attempt to crystallise these issues with the Australian Taxation Office.

Issues to note

The decision identifies the importance of several key concepts:

  1. First, it is incredibly important for client and their advisors (legal, accounting, and financial etc) to determine the issues which cannot be resolved by agreement.
  2. Second, where issues cannot be resolved by agreement, it is vital that clients, the parties more broadly and their respective advisors work together to ensure that all relevant evidence is adduced to the Court to enable it to undertake its primary function of determining disputes.
  3. Third, at the very least, the Court requires evidence of the bare minimum of tax payable by the parties or their entities.
  4. Fourth, there can be significant cost and other consequences for parties and related businesses if the matter is not conducted properly and with a resolution / solution focus.

Emmerton & Manwaring [2023] FedCFamC2F 476

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