Australia: Proposed changes to the tax monster that is Division 7A

Submissions to Treasury

Submissions have now closed to Treasury concerning their Consultation Paper "Targeted Amendments to Div. 7A Integrity Rules" (October 2018 – Consultation Paper).

Whilst it is hoped that the submissions to Treasury may finally provide some worthwhile improvements to Div. 7A, the fact that this whole process started in May 2012, and as of today, the limited proposed amendments still lack the required detail, there is little doubt that the monster Div. 7A has turned into, is not about to be constrained.

Div 7A replacement to s108 in 1997

When Div. 7A was introduced in 1997 to replace section 108, dealing with the release of private company profits to shareholders (or associate of shareholders), they seemed to be largely sensible measures that would allow a taxpayer to self-assess whether they had a deemed dividend, rather than the Commissioner having to form an opinion that there had been a release of profits before section 108 applied.

50% CGT discount in 1999

The introduction in 1999 of a choice for individuals and trusts (with presently entitled beneficiaries) to elect to take a 50% discount on capital gains (in place of indexation), created a bias in favour of appreciating capital assets being held in trusts rather than companies.

UPEs to fund trust trading

This together with the fact that many private enterprises preferred trusts as their trading and asset holding entities, rather than companies, put together with a desire to access the lower corporate rate (30%), led trusts to make corporate beneficiaries presently entitled to trust income, but the entitlement was not paid out (an Unpaid Present Entitlement-UPE). This method obtained the corporate tax rate, but allowed for the ongoing funding of the business activities of the trust.

ATO U-turn on UPEs

In December 2009, alarmed by these developments, the ATO changed its position in relation to UPEs owed by trusts to companies, and argued that the allowing of the UPE to remain outstanding represented a "financial accommodation", to be within the extended definition of "loan" in section 109D of Div. 7A. This was a U-turn, which was met with considerable dismay resulting in the ATO proposing some ameliorating measures to soften the blow of their change of position (TR 2010/3 & PSLA 2010/4). As a result of this turmoil, in May 2012, the Government commissioned the Board of Taxation to undertake a "Post-implementation review of Div. 7A".

Board of Taxation

The Board's First Discussion Paper was released in December 2012. In November 2013 the terms of reference were extended to include consideration of Div. 7A in the context of the broader tax framework, a Second Discussion Paper was released in March 2014. The Board then provided its Final Report to Government in November 2014.

The Board's Final Report made far reaching recommendations in relation to the operation of Div. 7A.

Government's response

The Government's response to the Board's Final Report was to announce, with very little detail, relatively modest amendments as part of the 2016/17 budget, to apply from 1 July 2018:

  • A self-correction mechanism to assist taxpayers to rectify "breaches of Div. 7A promptly".
  • Appropriate safe harbour rules to provide certainty and simplify compliance for taxpayers.
  • Simplified rules regarding complying Div. 7A loans, including in relation loan duration and the maximum interest rate.
  • A number of technical amendments to improve the integrity of the operation of Div. 7A, and to provide increased certainty for taxpayers.

In the 2018/19 Budget, the Government announced that it was deferring the start date of the 2016/17 proposed amendments, and in addition, confirmed that UPEs would come within the scope of Div. 7A (rather than be administratively treated as such).

All amendments were specified to take effect from 1 July 2019.

Treasury consultation

Treasury released a Consultation Paper on 22 October 2018 posing, in reality, some 22 issues upon which they wanted to hear from stakeholders.

Distributable surplus

Some of Treasury's consultation points are indeed alarming as they do not go into the detail of seeking to implement the Board's recommendations in its Final Report, but rather, propose the complete opposite. For example, the Board recommended that the concept of "distributable surplus" be maintained, but Treasury proposes to abolish it! This would mean that capitalising up a private company with $1M, and then borrowing the money straight out again would give a $1M deemed dividend. This is outrageous.

Pre-Dec 2009 UPEs

On the other hand, the Board recommended that pre-December 2009 UPEs be brought into Div. 7A, whereas Treasury asked the question of whether they should be, without any discussion. The 2018/19 Budget certainly made it clear that future UPEs would necessarily come within the scope of Div 7A.

Submissions to Treasury have made it clear that bringing pre-December 2009 UPEs into Div 7A would be a highly retrospective amendment and cause affected taxpayers considerable hardship.

10 Year Loan Model

Other measures upon which Treasury are consulting are a proposed 10-year Loan Model to replace the existing unsecured 7-year and secured 25-year loan arrangements, and rejecting the Amortisation Model recommended by the Board. The Amortisation Model proposed by the Board contemplated flexibilities to the payments of both interest and principal, with minimum payments of interest and the principal not required annually, but rather at the end of years 3, 5, 8 and 10. The Amortisation Model had garnered broad support as it represents an appropriate balance of flexibility for borrowers in terms of cash flow management and the need to ensure, from a policy perspective, that regular payments of both principal and interest are made to the company lender.

No "Business Income Election"

The Board has also recommended that if the Amortisation Model was adopted, trusts should be allowed to make a once and for all election for loans from companies (including UPEs owed to companies), to be excluded from the operation of Div. 7A (the "Business Income Election"). The Treasury Consultation Paper does not refer to the Business Income Election, which is also disappointing.

Start Date

Whether the 1 July 2019 start date can be relied on, needs to take into account that the Federal Election must be held by May 2019, with the Government having scheduled only 10 sitting days before it anticipates going into caretaker mode, so that no new legislation will be introduced from the date of the announcement of the election. Further, that the next Budget has been brought forward to April 2019, which may result in further changes to the proposed amendments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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