Deemed Dividends under Self-Ownership Buy/Sell Agreements

split taxable income between a number of taxpayers; and
minimise their personal exposure to creditors of the Business, litigation and the risk of bankruptcy.

In these cases, some or all of the Equity in the Business might be owned by a Third Party such as a Spouse, Company or Family Trust.

This situation will arise if:

the Business is a Partnership, and a Company is one of the Partners;
the Business is a Company, and another Company is one of the Shareholders; and
the Business is carried out through a Unit Trust, and a Company is one of the Unit Holders.

Ownership of Equity by Company

Where the Equity in a Business is owned by a Company, Self-Ownership of the Buy/Sell Cover could give rise to a deemed dividend that is subject to income tax in the hands of the Life Insured (over and above any CGT liability that would be payable by the Vendor).

It is arguable that the payment to the Life Insured would constitute a deemed dividend under section 109C of the Income Tax Assessment Act 1936.

Section 109C of the ITAA 1936

Section 109C provides as follows:

"A private company is taken to pay a dividend to an entity at the end of the private company's year of income if the private company pays an amount to the entity during the year and either:

(a) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been such a shareholder or associate at some time."

Commissioner of Taxation v Rozman

In Commissioner of Taxation v Rozman [2010] FCA 324 (1 April 2010), Perram J. of the Federal Court held that the word "payment" includes a payment by another party at the direction of the Company.

Thus, it is not necessary that the Company itself directly make the payment to the Shareholder or Associate of the Shareholder.

Application of Section 109C to Buy/Sell Situations

In a Buy/Sell situation, the Company would normally be expected to receive the Sale Price as the consideration for the Equity it owns and must transfer to the Purchasers under the Business Succession Agreement.

Self-Ownership is simply a strategy to avoid the Capital Gains Tax that would be payable in some circumstances, if the Purchasers owned the Buy/Sell Cover.

Self-Ownership effectively requires the Insurance Proceeds attributable to the Sale Price to be paid directly to the Life Insured (rather than the Company Vendor).

it is arguable that the payment is made to the Life Insured by the Insurance Company:

at the direction of the Company; or
in accordance with an arrangement pursuant to which the Life Insured (rather than the Company itself) effectively receives the Insurance Proceeds as consideration for the transfer of the Equity held by the Company .

Thus, it is arguable that there would be a deemed dividend and income tax payable with respect to the deemed dividend at the Life Insured's marginal tax rates.

This income tax liability would be additional to any Capital Gains Tax liability as a result of the sale of the Equity by the Related Party Vendor.

Comparison with Payment to Related Party Vendor under Trust Ownership

Trust Ownership is designed to pay the Insurance Proceeds attributable to the Sale Price to the appropriate Related Party Vendor.

If the Sale Proceeds were paid to the appropriate Vendor, it would be responsible for payment of the CGT liability.

The amount of Capital Gains Tax would be the the same as would be deemed to be payable under Self-Ownership as a result of the Market Value Substitution Rules.

However, in the case of Trust Ownership, the Vendor's CGT liability would reduce the amount of the Net Sale Proceeds available for distribution as a dividend.

In other words, the amount available for distribution as a dividend would be the Net Sale Price after payment of the CGT liability.

If there was no CGT liability, then the amount of the dividend (and therefore the income tax liability) would be potentially higher, because the whole of the Sale Price would be available for distribution.

However, in the case of Self-Ownership of the Buy/Sell Cover, the whole of the Insurance Proceeds attributable to the Sale Price will always be paid to the Life Insured by the Insurance Company (subject to the availability of adequate Cover).

Therefore, the deemed dividend will always be equivalent to the gross amount of the Sale Price.

There would be no deduction for any CGT liability payable by the Related Party Vendor (subject to any allowance under section 109Y).

In fact, if there was a CGT liability, the Vendor would have to pay it out of funds other than the Insurance Proceeds.

As a result, in cases where there is a CGT liability with respect to the sale of the Equity, Self-Ownership will result in a higher tax liability than would have applied under Trust Ownership.

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