On 22 October the Treasury released it’s Consultation Paper on Division 7A. The paper proposed a number of amendments as shown below.
There will be one “10 year loan model” for all loans made by private companies. The existing 7 and 25 year loan options will be discontinued. Any existing loans will be transitioned to the new 10 year loan model.
|New loan rules will be implemented for complying Division 7A loans. The loan model will have a maximum term of 10 years with a variable interest rate and payments of both principal and interest in each income year.
The maximum term of a loan will be 10 years. Consistent with current practices, the loan effectively begins at the end of the income year in which the advance is made. This is because the taxpayer is given until the lodgment day (the earlier of the actual date of lodgment or lodgment due date) of the private company’s income tax return to repay the loan or put it on complying loan terms.
The minimum yearly repayment amount consists of both principal and interest:
Where the minimum yearly repayment has not been made in full any shortfall will give rise to a deemed dividend for the year. This is consistent with the current laws.
Repayments of the loan made after the end of the income year but before the lodgment day for the first income year are counted as a reduction of the amount owing even if they are made prior to the loan agreement being finalised.
|The current Division 7A loan model includes complex rules relating to apportionment of repayments between principal and interest. These rules place an administrative burden on advisors and taxpayers. The new ten year loan model is simpler than the current apportionment model and more closely aligned to commercial practice for principal and interest loans.
This loan model is preferred from a policy perspective as annual payment encourages proactive cash flow management by businesses and reduces the size of payments (ten smaller payments) relative to the Amortisation Model in the Board of Taxation report. It is also easier to calculate the required interest and principal repayment amounts than under the Amortisation Model.
Similarly, although an interest only model is simple in operation, it is not consistent with the policy intent behind Division 7A which requires repayment of principal over time. This is because there is an expectation that amounts borrowed from private companies will be returned over time to shareholders as dividends and taxed at the shareholders’ marginal tax rates.
| The 10 year loan model, in principle, will create a simpler set of rules for the majority of taxpayers.
There are some issues (discussed below).
The removal of the 25 year loan option will create a limit on the type of investments that Division 7A loan can be used to finance.
The annual benchmark interest rate will be the Small business; Variable; Other; Overdraft – Indicator lending rate most recently published by the Reserve Bank of Australia prior to the start of each income year.
|The change in the indicator lending rate to be used for Division 7A purposes was suggested by the Board of Taxation in the context of an interest only loan concept.||The existing benchmark interest rate is the “Loans; Banks; Variable; Standard; Owner-occupier” indicator lending rate published by the RBA which currently is 5.2%. The modified benchmark interest rate would be 8.3%.
Where the loan is being repaid progressively over the term of the loan (which is the case under the 10 year loan model) as opposed to having interest only terms (under the model proposed by the Board of Taxation) there would appear to be no rationale to support increasing the benchmark interest rate.
This is not a change that simplifies the law, it would just be a change in increase the cost to shareholders in private companies of accessing the funds in those companies.
There will be no requirement for a formal written loan agreement, however written or electronic evidence showing that the loan was entered into must exist by the lodgment day of the private company’s income tax return. This evidence must show:
|The proposed approach is a missed opportunity for simplifying Division 7A.
Currently a written loan agreement needs to be put in place before the lodgment date. This is an administrative burden, but one that most advisors are now well practiced at managing.
The change would only take away the need for the formal loan agreement.
In its place is a need to evidence the entering into of a loan arrangement and it terms. This opens a new area of potential dispute.
A preferred alternative would be for advances made by a private company to a shareholder/associate to automatically fall under the 10 year loan model unless the parties can evidence a contrary intent, i.e. an opt out approach. This would be a simplification from the current situation.
Interest is calculated for the full income year, regardless of when the repayment is made during the year (except Year 1). If the loan is paid out early, that is before Year 10, interest will not be charged for the remaining years of the loan.
|The current Division 7A loan model includes complex rules relating to apportionment of repayments between principal and interest. These rules place an administrative burden on advisors and taxpayers. The new ten year loan model is simpler than the current apportionment model and more closely aligned to commercial practice for principal and interest loans.||There is limited rationale for this approach. Most private company groups are accustom to dealing with commercial loan arrangements. The interest on Division 7A loans should be calculated on a commercially realistic basis, not in the artificial way that is being proposed.
Under the proposed approach, an advance made on 30 June and repaid on 1 July would attract a full year of interest. This is not justifiable.
If this proposed change is actually adopted, there will be a significant need for pre-planning by any private company groups making any loans to shareholders/associates.
|Transitional rules – 7 year loans
All complying 7 year loans in existence as at 30 June 2019 must comply with the new proposed loan model and new benchmark interest rate to remain complying loans, but will retain their existing outstanding term.
For instance, a loan maturing 30 June 2021 will continue to mature on this date. This means that under the transitional rules, its remaining term will be 2 years. The outstanding loan balance would be repayable over 2 years, and interest would be charged using the new benchmark interest rate under the proposed model.
Current loan agreements with written reference to the benchmark interest rate should not be required to be renegotiated under this option.
|Subject to the proposed changes to the benchmark interest rate and interest calculation, transitioning existing 7 year loans to 10 year loans would appear to have limited issues associated with it.|
|Transitional rules – 25 year loans
All complying 25 year loans in existence as at 30 June 2019 will be exempt from the majority of changes until 30 June 2021. However, the interest rate payable for these loans during this period must equal or exceed the new benchmark interest rate.
On 30 June 2021, the outstanding value of the loan will give rise to a deemed dividend unless a complying loan agreement (10 year loan model) is put in place prior to the lodgment day of the 2020-21 company tax return. The first repayment will be due in the 2021-22 income year.
|Where the existing 25 year loan has a remaining term of 12 years or less, subject to the proposed changes to the benchmark interest rate and interest calculation, transitioning to 10 year loans would appear to have limited issues associated with it.
Where the existing 25 year loan has a longer remaining term, this change would have a potentially material financial impact.
Businesses and shareholders have made long term investment decisions based on tax laws that permitted a 25 year loan at a particular indicator lending rate. Any change in the tax laws needs to have strong regard to the impact on the investment decisions that have been made.
A preferred approach would be to allow an option for existing 25 year loans to remain in place based on their current terms. There would be no new 25 year loans being created, so over time all loans would transition to the new 10 year loan model.