Introduction

BNR Partners regularly consults on the potential impact of Division 7A of the Income Tax Assessment Act (1936) on its clients including private companies that form part of a deceased estate.

To recap, Division 7A ensures that the making of a payment or loan by a private company to a shareholder or associate, or the forgiveness of a debt owed by the shareholder or associate to the private company, is treated as an assessable unfranked dividend to the shareholder or associate for the amount of that payment, loan or debt forgiveness unless an exception applies.

Our in-house Senior Tax Counsel Mark Morris has extensive experience in consulting on Division 7A and has compiled a summary of the proposed reforms to those provisions set out in a recent Treasury Consultation Paper which will add to the complexity and severity of Division 7A should these changes apply from 1 July 2019 as currently proposed.

Background

The Board of Taxation issued a report entitled ‘Post Implementation Review of Division 7A of Part III of the Income Tax Assessment Act (1936)’ (the ITAA (1936)) on 4 June 2015 which proposed key changes to reduce the complexity of Division 7A.

In the 2016-17 Federal Budget a brief reference was made to ‘targeted amendments to Division 7A’ in Budget Paper No.2 which briefly stated that there would be amendments in respect of the following:

  • A self-correction mechanism for inadvertent breaches of Division 7A;
  • Certain safe harbour rules;
  • Simplified Division 7A loan arrangements; and
  • Various minor technical amendments.

In the 2018-19 Federal Budget the Federal Government further confirmed its intention to proceed with the proposed amendments, and also announced that an Unpaid Present Entitlement (UPE) owed to a private company by a related trust would be brought within the scope of Division 7A.

Both of these changes were proposed to apply from 1 July 2019.

Treasury Consultation Paper

The Assistant Treasurer Mr. Robert subsequently issued a Treasury Consultation Paper entitled ‘Targeted amendments to the Division 7A integrity rules’[1] on 22 October 2018 setting out amendments proposed by Treasury to improve the integrity and operation of Division 7A of the ITAA (1936).

It is to be noted that the Treasury Consultation Paper ignores many of the earlier recommendations made by the Board of Taxation particularly those measures designed to make compliance more straightforward for taxpayers. It is unclear whether this change in policy has been made by the Federal Government or is merely a position which has been adopted by Treasury who only invited submissions on the proposed changes up until 21 November 2018.

The major proposed amendments in the Treasury Consultation Paper are summarised below:

  1. New Division 7A loan rules

Under the proposed changes a single loan model will be introduced in respect of any loan made by a private company to a shareholder or associate in lieu of the current regime which essentially sets out different rules for unsecured loans with a term of 7 years and certain secured loans with a term of 25 years. The proposed introduction of such a profound change is subject to a range of transitional measures.

The proposed single loan model will have the following features:

  • All loans from 1 July 2019 are to be made for a maximum term of 10 years;
  • A new annual variable benchmark interest rate will apply being the ‘Small Business Variable Other Overdraft-Indicator Lending Rate’ published by the Reserve Bank of Australia prior to the start of a particular income year;
  • Interest must be calculated for the full year regardless of when repayment is made (other than for the first year);
  • Principal and interest loan payments will be required annually (with the loan principal to be repaid in 10 equal annual instalments). Any shortfall in any minimum annual repayment of these amounts will be treated as a deemed dividend;
  • No written loan agreement will be required (but there must be some written or electronic evidence showing the loan was entered into by the lodgment day being the due date for lodgment of the company’s income tax return. Such evidence must show the parties to the loan; details of the date of execution of the loan; the loan terms including the amount of the loan, the date the loan was drawn down, the requirement to repay the loan, the term of the loan and the interest rate payable);
  • All 7-year loans in place at 30 June 2019 are to come under the new rules for the remaining life of the loan term including the application of the new benchmark interest rate from 1 July 2019;
  • All 25-year loans in place at 30 June 2019 will be exempt from the proposed changes until 30 June 2021 other than the requirement to calculate interest based on the new benchmark interest rate. From 1 July 2021 such loans will effectively become subject to all the other requirements of the proposed single loan model for loans with a maximum term of 10 years; and
  • All pre-4 December 1997 loans will fall under the proposed new rules at 30 June 2021 and therefore will have to be either repaid in full or placed under a complying 10-year loan arrangement by the lodgment date of the company’s income tax return for the year ended 30 June 2021.

 

  1. Removal of distributable surplus

The proposed amendments will remove the concept that a deemed dividend arising under Division 7A of the ITAA (1936) will be limited by the distributable surplus of the private company that provided the benefit to the shareholder or associate.

In Treasury’s view capping the amount of the deemed dividend to a private company’s distributable surplus is contrary to the efficient operation of Division 7A. Accordingly, under this foreshadowed change the entire value of any benefit extracted by a shareholder or associate will be included in their assessable income and subject to tax.

According to Treasury this will allow the treatment of deemed dividend under Division 7A to be aligned with the treatment of a dividend under section 254T of the Corporations Act 2001(Cth) which allows dividend to be paid out of both profits and capital.

  1. Unpaid Present Entitlement (UPE)

It is proposed that a UPE arising on or after 1 July 2019 must either be paid out to the private company or put on a complying 10-year loan basis by the lodgement day of the company for the particular year in order to avoid being considered a deemed dividend.

A UPE that have previously been placed on complying loan terms will be treated in accordance with the transitional rules proposed to apply to existing standard 7 or 25 year complying loans described above.

In addition, UPE’s arising on or after 16 December 2009 and before 30 June 2019 that have not been already placed on a complying loan basis must be put on such a compliant loan basis by 30 June 2020. Where this does not occur the outstanding amount of any UPE will be treated as a deemed dividend.

The Board of Taxation has also canvassed whether UPEs arising prior to 16 December 2009 should be brought within the scope of Division 7A. Hence, it is unclear whether  quarantined pre-16 December 2009 UPE’s will be subject to the above foreshadowed complying loan rules, and if so, what transitional arrangements may apply to such UPEs.

  1. Amendment Periods

The period during which an amendment may arise in respect of transactions and events falling within Division 7A will be extended to 14 years after the end of the year in which the payment, loan or debt forgiveness which gave rise to a deemed dividend under Division 7A arose. It is proposed that this change will also apply from 1 July 2019.

  1. Self-correction mechanism

Taxpayers will be able to self-assess their eligibility to take corrective action and reverse the effect of a prior year deemed dividend arising under Division 7A without incurring penalties.

To be able to take advantage of the self-correction opportunity it would be necessary that a taxpayer satisfy the following eligibility criteria:

  • When viewed objectively the breach of Division 7A was an inadvertent breach;
  • Appropriate steps have been taken as soon as practicable, (and no later than six months after identifying the error unless the Commissioner allows more time), to ensure that affected parties are placed in the same position they would have been had they complied with their obligations; and
  • The taxpayer has taken all reasonable steps to identify and address any other breaches of Division 7A.

Under this approach the corrective action undertaken by an eligible taxpayer must:

  • Convert the benefit arising from the breach into a complying loan agreement whose terms are the same as that which would have applied had a loan agreement been entered into at the time of the breach; and
  • Make catch up payments of principal and interest that would have been payable as prior year minimum yearly repayments had the taxpayer complied with Division 7A when it should have. The interest component of the catch-up payment will be compounded to reflect prior year non‑repayments. This compounded interest should also be declared as assessable income in the private company’s income tax return for the income year in which the catch-up payment is made.

As a corollary to the above changes the existing Commissioner’s discretion under section 109RB of Division 7A of the ITAA (1936) will be amended so that it will only apply in respect of the exercise the Commissioner’s discretion to frank a dividend.

  1. Safe Harbours for use of company assets

Where an asset is provided for use by a private company to a shareholder or associate, the amount of the deemed dividend is the amount that would have been paid for the provision of the asset by parties dealing at arm’s length less any amounts actually paid by the shareholder or associate for the use of the asset under section 109CA.

However, when a private company’s assets are used by a shareholder or associate in circumstances that cause section 109CA to apply, a significant difficulty has been to determine the value which arises from the use of the asset by that entity.

Under the proposed changes taxpayers will have the option of adopting a safe harbour formula where the arm’s length amount will be the value of an asset multiplied by a stipulated interest rate for each day of use of the asset. However, taxpayers will continue to be able to use their own calculation of the arm’s length value of the benefit such as applying equivalent arm’s-length values instead of the legislative formula should they choose to do so.

The proposed sale harbour rule will apply to all of a private company’s assets other than motor vehicles whose market value is usually readily ascertainable where the vehicle is rented on an arm’s-length basis.

Very broadly, the proposed safe harbour formula will involve the value of the asset at 30 June being multiplied by benchmark interest rate plus a 5% uplift.

This formula will then be applied on a daily basis and on the daily rate being multiplied by the number of days during the income year in which a shareholder or associate used or had the right to use the private company’s asset.

For these purposes the value of an asset will be its cost (inclusive of any improvements made over the life of the asset). Where an asset is held for more than five years, the value of the asset will instead be the greater of its cost or value as determined by market valuation. In addition, a formal market valuation of the asset will be required every five years.

The application of the above formula is best illustrated by the following example which is taken from the Treasury Consultation Paper:

Sesame Pty Ltd owns a yacht valued at $1,200,000. Bert invites his friends Ernie and Oscar to spend the day on the yacht one Sunday every month. Bert has no right to use the yacht at any other time during the income year. The benchmark interest rate for the income year is 8.5 per cent. Therefore, the interest rate used in the formula is 13.5 per cent.

The charge is calculated as follows:

$1,200,000 X (13.5%/365) = $443.84 per day

The yacht was used for 12 days over the income year. Therefore, the deemed dividend calculated according to the safe harbour formula is approximately $5,326 (being $443.84 X 12).

  1. Minor Technical Amendments

Various other minor technical amendments are proposed which include:

  • Changing the timing rules applicable under section 109CA so that it will apply from the first day in an income year that a shareholder or associate uses the asset or has a right to use the asset regardless of whether this is an exclusive right to use the asset or not. That is, the deemed payment provisions of section 109CA could apply where an entity receives a valuable non-exclusive right to use a private company asset where the private company also maintains a right to use the asset;
  • Modifying the exemption under section 109G(3) which provides that a forgiven debt to an entity will not give rise to a deemed dividend if the loan that resulted in the debt had given rise to an earlier deemed dividend under section 109D. Subsection 109G(3) will be amended to ensure this exception only applies where the earlier dividend that the company was taken to have paid under section 109D has been taken into account in the income tax assessment of the debtor entity;
  • Modifying the exemption under section 109M to make it clear that the exclusion is limited to situations where there is a loan made in the ordinary course of carrying on a money lending business to third parties rather than a loan made in the ordinary course of carrying on any business. Such loans by money lending companies must continue to be required to be made on the usual terms on which a money lending company makes loans to third parties on an arm’s length basis;
  • Amending the interposed entity rules in section 109T(1) to address the situation where the benefit provided to the interposed entity differs from that ultimately provided to the taxpayer. Under this proposed change section 109T(1) will apply in any case were a loan, payment or other benefit is indirectly provided to a taxpayer if a reasonable person would conclude this benefit would not have been provided but for a loan, payment or other benefit being provided to an interposed entity;
  • Clarifying section 109Z to make it clear that a payment that is deemed to be a dividend under Division 7A is non-deductible; and
  • Clarifying the rules that apply where an entity is both an employee of the private company and a shareholder the private company and the related interaction between Division 7A and the FBT provisions. This does not currently appear to involve any change in policy or interpretation.

[1] A copy of the Treasury Consultation Paper can be downloaded at https://treasury.gov.au/consultation/c2018-t227294/