Division 7A – Proposed Changes

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:

• The principal component is a series of equal annual payments over the term of the loan.
• The interest component is the interest calculated on the opening balance of the loan each year using the benchmark interest rate.

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:

• the parties to the loan;
• the agreement that the loan be made, including details of the date and evidence of its execution and binding nature on the parties to the agreement; and
• the loan terms (the amount of the loan, the date the loan was drawn, the requirement to repay the loan amount, the term of the loan and the interest rate payable).

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.

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.

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).

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.

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.

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.

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:

• on the basis of objective factors, 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 position they would have been in had they complied with their obligations; and
• the taxpayer has taken, or is taking, reasonable steps to identify and address any other breaches of Division 7A.

Under this approach, in order to self-correct an eligible taxpayer must:

• convert the benefit into a complying loan agreement, on the same terms that would have applied had the loan agreement been entered into when it should have been; and
• make catch-up payments of the principal and interest that would have been payable as prior 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 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.

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.

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.

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:

Where:
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 value of the asset is its cost – this includes any improvements made over the life of the asset. Where an asset is held for more than five years, its value will instead be the greater of the cost or the value determined by a market valuation. This is to ensure that the formula, at a minimum, reflects the cost of the asset to the business while ensuring the increase in value for appreciating assets (e.g. real property) is factored into the calculation;
• a formal market valuation of the asset is required every five years;
• the charge is based on actual number of days used by the shareholder (or their associate), unless the shareholder (or their associate) have the exclusive right to use the asset at other times; and
• the rules apply to both appreciating and depreciating assets.

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.

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:

• in the ordinary course of a business of lending money to third parties;
• on an arm’s length basis; and
• on the usual terms on which the private company makes similar loans to parties at arm’s length.

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.

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.

• the exception in subsection 109ZB(3), which provides that Division 7A does not apply to payments made to shareholders (or their associates) in their capacity as an employee (or an associate of such an employee), only applies where that payment would constitute a fringe benefit. In determining if a payment is a fringe benefit within the meaning of subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986, paragraph (r) should be disregarded;
• former shareholders (or their associates) should be treated consistently with current shareholders. The exception in subsection 109ZB(3) will be extended to ensure that Division 7A will not apply to payments to former shareholders or associates of former shareholders in their capacity as an employee if the payment was a fringe benefit; and
• FBT will not apply to payments to former shareholders and their associates that are otherwise captured by Division 7A.

These amendments will clarify and provide integrity in relation to the interaction between Division 7A and the FBT provisions.

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.