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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.
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.
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.
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.
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:
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.
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.
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.
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 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.
Old s108 loans
Old s108 loans (being loans that pre-date the introduction of Division 7A in 1997) will become subject to Division 7A. Commencing from 2022, these loans will need to be repaid based on the 10 year loan model.
Under the transitional rules, pre-1997 loans will be taken to be financial accommodation as at 30 June 2021. The taxpayer will have until the lodgment day of the 2020-21 company tax return to either pay out the amount of the loan or put in place a complying loan agreement, otherwise it will be treated as a dividend in the 2020-21 income year. The first repayment will be due in the 2021-22 income year.
The stated rationale for the change is weak. The real rationale would appear to be a desire to have all taxpayers on the same footing in relation to loans from private companies. There is also a perception that these loans should be brought to tax at some point in time – many of these loans will have been outstanding for over 20 years with no repayments being made or interest charged. Left to the taxpayer, it is doubtful that many of these loans will be repaid any time soon.
Against the proposed change is the view that the change is effectively retrospective, as these loans were made in compliance with the terms that existed at the time.
Treasury, like the Board of Taxation, seem clear in their view that these loans need to be brought into the Division 7A system. If this is to be the case, an extended transitional in warranted so that the financial impact on affected taxpayers is manageable.
This is an area where significant pre-planning is going to need to be undertaken by private groups.
Caution should be exercised before proceeding on the basis that a loan has become statute barred. This is a complex legal question where the rules vary between States, and where the interaction with Division 7A is potentially flawed and the intended outcome may not actually be achieved.
Forgiving a loan
The forgiveness of a loan that has previously been deemed to be a dividend does not give rise to a further deemed dividend. This is the case even if the first deemed dividend was reduced (due to the distributable surplus rules) or where the deemed dividend was never included in the shareholder’s tax return and the amendment period has now expired. The proposed change would require that the deemed dividend was actually included in the shareholder’s tax return for the subsequent forgiveness of the debt not to trigger further Division 7A implications.
However, section 109G sets out a number of exceptions to this general rule. In particular, subsection 109G(3) provides that a forgiven debt will not give rise to a dividend if the loan that resulted in the debt gave rise to a 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 has been taken into account in the income tax assessment of an entity or entities.
It would seem reasonable to tax windfall benefits, such as where a taxpayer fails to include an earlier deemed dividend in their tax return.
However, where the loan arose in circumstances where there was no distributable surplus, it would suggest that there was no profits in the company so the policy of Division 7A (shareholders accessing profits of private companies without paying appropriate tax are personal marginal rates) would not appear to be offended. This change may not be warranted in these circumstances, or the change may only be appropriate to apply to loans created after the distributable surplus concept is removed (which is one of the proposed changes).
Non-resident private companies
Division 7A applies to payments, loans and forgiven debts by private companies regardless of the residency or place of incorporation of the private company. This leads to an unnecessarily complex analysis for some taxpayers as Division 7A, in theory, deems a dividend to arise to a non-resident shareholder that receives a loan from a non-resident private company that has no Australian sourced profits or Australian based assets. It is only through recourse to other parts of the tax laws that this scenario does not result in taxable income arising.
Some stakeholders have highlighted that the application of Division 7A to non-resident private companies in certain circumstances continues to be uncertain – for example whether it applies only where the shareholder of the private company (or their associate) is an Australian resident, how ‘source’ considerations apply to the deemed dividend and how the provisions potentially interact with the transfer pricing rules and double tax treaties.
Division 7A should only apply where, had a dividend been paid in the same circumstances, the shareholder/associate would have been assessable on the dividend. This would require that the shareholder/associate is an Australian tax resident.
Currently a Division 7A deemed dividend is limited to the distributable surplus of the private company. Distributable surplus is a proxy for profits, although it is poor proxy in many cases. The proposed change is to apply Division 7A to the economic benefit received by the shareholder/associate. This would be achieved by removing the concept of a distributable surplus.
This will ensure the integrity of Division 7A so that dividends can be deemed for the entire value of the benefit that was extracted from the private company.
This will also align the treatment of dividends with section 254T of the Corporations Act 2001 (Cth) which allows dividends to be paid out of both profits and capital.
This change may appear more of an issue than what it truly is.
Reliance on the absence of a distributable surplus to argue no Division 7A deemed dividend can often by misplaced as the interposed entity provisions could have application (where did the no distributable surplus get the funds from in order to make the loan?).
Safeguards will be needed to ensure distributions of share capital are not deemed to be dividends.
The section 254T rationale is flawed. Alignment with the Corporations Act position is not achieved.
Unpaid present entitlements
The ATO’s interpretation of the Division 7A treatment of UPEs changed in December 2009. From that time, the ATO’s view became that UPEs are loans for Division 7A purposes. Any question over this treatment will be addressed by the proposed change which will legislate that UPEs are to be treated consistent with loans for Division 7A purposes.
All UPEs that arise on, or after, 1 July 2019 will need to be either paid to the private company or put on complying loan terms under the new 10-year loan model prior to the private company’s lodgment day, otherwise they will be a deemed a dividend.
Particular care will be needed in dealing with specific asset sub-trusts. Greater transitional measures may be required in relation to these arrangements. This is one of the questions raised in the consultation paper.
Whilst it is raised as a question in the consultation paper, it is difficult to see a situation where pre 2009 UPEs will be excluded from Division 7A but all other UPEs and all loans will be included.
One of the areas where UPEs were most frequently used was to allow a trust that operated a business to retain funds for working capital purposes where the funds were only taxed at the corporate tax rate.
Although exceptions in tax laws tend to create complexity, an exception may be warranted for pre 2009 UPEs where the funds have been applied for income producing purposes – i.e. an otherwise deductible rule.
Private groups with pre 2009 UPEs will need to start planning for these proposed changes.
Self correction of errors
The existing restricted mechanism for correction of errors in prior year Division 7A positions will be removed and replaced with an expanded self assessed correction mechanism.
To qualify for self-correction, the taxpayer will need to meet eligibility criteria in relation to the benefit that gave rise to the breach. The eligibility criteria will require that:
Under this approach, in order to self-correct an eligible taxpayer must:
In certain cases, the concept of self-correction may include other appropriate action considered reasonable by the Commissioner based on the taxpayer’s circumstances. Reasonable circumstances would be set out by the ATO in its public advice and guidance products.
The correction mechanism required an exercise of discretion by the Commissioner, rather than self-assessment.
Further, the grounds on which the Commissioner could exercise the discretion were quite narrow.
Period of review
A 14 year amendment period is being proposed for Division 7A. This is based on the 10 year loan term plus the standard 4 year amendment period.
This approach is consistent with other areas of the law in which there are an extended period of review, including capital gains tax and loss recoupment rules.
This proposed change would support a “opt out” basis for implementing the 10 year loan model.
Private use of assets
The use of assets of a private company by shareholders or their associates will be a payment (by definition) for Division 7A purposes. The amount of the payment is the market value of the usage, which can be difficult to ascertain. It is proposed that a safe harbour formula will be included in the legislation.
The taxpayer will continue to be able to use their own calculation of the arm’s length value instead of the legislative formula.The safe harbour will apply for the exclusive use of all assets excluding motor vehicles. This is because the market value for rental of a motor vehicle is readily ascertainable by other means.
The safe harbour will generally apply unless the taxpayer has received a non exclusive right to use an asset.
The proposed formula for the safe harbour is:
A = Value of asset at 30 June, for the income year in which the asset was used.
IR = benchmark interest rate plus 5 per cent uplift interest.
Days used = days shareholder (or their associate) used or had the exclusive right to use the asset.
Days in year = days in income year (i.e. 365 or 366).
The safe harbour will provide that:
The shareholder (or their associate) can avoid a deemed divided by ensuring that an arm’s length amount for usage is paid.
The determination of this arm’s length amount in some cases can be difficult to ascertain and increases compliance costs for taxpayers.
The Board of Taxation recommended the design of legislative safe harbours to facilitate compliance, reduce uncertainties and lower administrative costs for taxpayers. It was also suggested that the rules should distinguish between appreciating and depreciating assets.
However, this rule currently does not address the case where an entity receives a valuable non exclusive right (i.e. where the provider maintains a right to use the asset). In this case, while a payment will be taken to be made, the time at which the payment is taken to be made is ambiguous. This is an unintended anomaly.
Loans made in the ordinary course of business
Loans made by a private company in the ordinary course of its business are excluded from Division 7A. There has been some ambiguity over the scope of this exception: for example, does an internal group finance company fall within these rules? The confusion is compounded by recent ATO guidance on when a company will be considered to be carrying on a business. The proposed amendments will limit the scope of the exception to the generally accepted position, being that it only applies to private company that make loans in the ordinary course of a business of lending money to third parties.
Section 109M was intended to operate so that a private company will not be taken to pay a dividend only in circumstances where the loan is made:
It is noted that the ATO has recently updated its guidance on when a company carries on a business and that this may have flow-on effects for the operation of this provision.
Interposed entity rules
The interposed entity rules are an integrity rule within Division 7A to capture loans or payments made indirectly (via other entities) from a private company to a shareholder or associate. The proposed amendment would strengthen the tests for when the interposed entity rules could be applied.
This change ensures the provision gives effect to the underlying policy intention to bring to account indirect benefits, even if the payment or loan that results in the indirect benefit also has other commercial purposes.
We would suggest that the interposed entity rules are a component of Division 7A that requires greater review and amendment to reduce its complexity.
The interposed entity rules are already an incredibly broad set of rules. They capture numerous factual situations that do not offend the policy of Division 7A, and it is only through the basis on which the Commissioner will make a determination to apply the rules that these situations don’t give rise to deemed dividends.
Shareholders and associates of private companies can often have multiple relationships with the company, such as being both shareholders and employees. The interaction of Division 7A and FBT in relation to benefits provided to these employee/shareholder situations is key. The proposed amendments will clarify some aspects of these interactions.
These amendments will clarify and provide integrity in relation to the interaction between Division 7A and the FBT provisions.
The proposed changes include an amendment to confirm that deemed dividends are not tax deductible.
Currently, payments, loans and other benefits that give rise to a deemed dividend are not deductible, but this is not specifically addressed in the legislation.
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