Many private companies make loans to their shareholders for a variety of reasons. Such loans made to shareholders may be deemed to be dividends to those shareholders under Division 7A of the Australian tax law unless certain criteria are met. Where the criteria are met, the loan amounts will continue to be treated as loans to the shareholders under the Division 7A rules.

In a peculiar situation where a shareholder of a private company dies before an outstanding Division 7A loan made to the shareholder has been repaid, various tax outcomes may arise depending on the circumstances of the shareholder’s deceased estate.

Upon the death of a shareholder to which a Division 7A loan has been made, the private company may forgive the loan on compassionate grounds to reduce the economic burden on the deceased estate to repay the loan. However, the ATO may deem a dividend to have been paid by the private company to the deceased estate. That is, a deemed dividend can arise on forgiveness of a loan and be taxable to the deceased estate.

Practically, though the amount of tax payable is likely to be less than the full repayment of the loan, the tax payable on the deemed dividend may not be an insignificant sum.

However, in the same situation but where the deceased estate declares bankruptcy as a result of having insufficient assets to settle its liabilities, a particular provision in tax law may operate to not treat the forgiveness of the loan as a deemed dividend. For this provision to operate, the cause of the debt forgiveness must be the bankruptcy of the deceased estate.

Evidently, no deemed dividend results in no additional tax liability for the deceased estate which may be seen as a positive outcome. However, bankruptcy law is complex and there may be undesirable outcomes as a result of declaring bankruptcy.

From the view of the private company, forgiving a loan assigned to a bankrupt deceased estate may result in a capital loss, but this would require the legal personal representative of the deceased estate to be discharged from all provable debts in accordance with the Bankruptcy Act 1966, or that the debt is forgiven under a deed of release.  Note that the capital loss is only deductible against assessable capital gains and not against other forms of income.

The interactions between shareholder loans, deceased estates and bankruptcy give rise to peculiar outcomes. Please contact us if you need advice relating to such situations.

Damien Lee

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