Article by Michaela Schmidt – Lawyer & Director
SNAPSHOT
Obtain advice on any proposed security arrangements, particularly where there is a company involved.
- Early action is critical
- If financial difficulties are anticipated call your bank before you default.
Bob and Sue, one of your favourite long-term clients, operated a cattle grazing business and, like many farmers, relied on bank funding to manage operating costs and seasonal fluctuations.
Their trading activities were conducted in their personal names (as a partnership), and the partnership’s bank borrowings of approximately $2million were also in their personal names.
The key farming asset, however, sat outside that structure. The 2,000 hectares was owned by a family company Bobsue Pty Ltd. Bob and Sue held all the shares in Bobsue Pty Ltd, and it had no external debt. For some time, the arrangement caused no problem.
Unfortunately, for all sorts of reasons, 2026 started off as a difficult year for Bob and Sue, cashflow tightened and the bank became concerned about the partnership’s capacity to meet ongoing commitments. When Bob and Sue approached the bank to discuss their position, the bank indicated it was prepared to continue its support, but only if additional security was provided.
The bank’s proposal was familiar: Bobsue Pty Ltd would provide a guarantee of the partnership’s borrowings, and that guarantee would be supported by a mortgage over the land owned by Bobsue Pty Ltd.
Bob and Sue attend your office with the guarantee documents and your immediate thought, thanks to a recent training session as part of your annual CPD, is to consider the potential application of Division 7A of the Income Tax Assessment Act 1936 (Cth).
As you’re reading through the guarantee document, you recall silently in your head that:
Division 7A can treat certain benefits provided by a private company to a shareholder (or an associate of a shareholder) as a deemed dividend. A company guarantee can be treated as the company providing financial accommodation. If Division 7A applies and the company has a distributable surplus (broadly, its net assets less paid-up capital), the shareholder/associate can be assessed on a deemed dividend up to the amount of that distributable surplus.
To address the immediate concern at the time of signing, you see that the guarantee is structured so that the company’s liability is ‘contingent’ – that is, Bobsue Pty Ltd would not become liable unless and until Bob and Sue defaulted under the facility.
You explain the rest of the guarantee document to Bob and Sue, have it signed and witnessed and email it to the bank. You are relieved that Bob and Sue are back on track as they are particularly good operators.
For a while, the arrangement operated as intended. The bank maintained the facility, and Bob and Sue continued trading.
The Sting
However, the risk with this type of structure is that the position can change quickly if there is a default.
Sadly, things took a drastic turn after Bob fell ill with pneumonia and later Bob and Sue missed an interest payment.
At the time the interest payment was missed, the terms of the guarantee operated so that Bobsue Pty Ltd’s obligation ceased to be contingent and became an obligation ‘other than contingent’. Therefore, the guarantee may be treated as Division 7A financial accommodation from the time the obligation of Bobsue Pty Ltd crystallised, being the date the interest payment was missed.
If Bobsue Pty Ltd has a distributable surplus, the consequences can be significant. Bob and Sue could face assessment on a deemed (unfranked) dividend on the amount of the loan guaranteed by Bobsue Pty Ltd, despite no cash being paid to them, at a time when the business is already experiencing financial pressure.
You consider whether there is any relief available and recall section 109UA(3) of the Income Tax Assessment Act 1936 (Cth) which gives the Commissioner a discretion to treat a deemed dividend as not having been paid in certain limited circumstances.
As described in the Explanatory Memorandum, the discretion is directed to situations involving hardship or events outside a person’s control, for example, where a borrower is involuntarily retrenched, or a technical default occurs, and the default is remedied shortly afterwards.
The discretion is not automatic, is fact-specific, and is typically narrow in operation. Although not an issue here, it is important to note that the section applies only to guarantees given after 27 March 1998.
The broader lesson from Bob and Sue’s experience is that a company guarantee should not be treated as a routine formality where shareholders (or their associates) are involved. Even where a guarantee is drafted to be contingent, the occurrence of a default can crystallise the obligation and create an unexpected Division 7A outcome.