Andrew Noolan CTA on 'The future of Division 7A'

In a paper presented at last November’s SME Symposium in Sydney, Andrew Noolan CTA looked at some of the issues he and many other practitioners have experienced over the years in relation to Division 7A.

He also covered the developments for 2017.

Andrew is a partner in the Sydney law firm, Brown Wright Stein Lawyers. His clients are accountants and lawyers in public practice who require advice on tax issues that impact their clients. He specialises in tax issues common to the SME and high-wealth-individual sectors.

In the paper, excerpted below, Andrew speculates on what action advisers might need to take in anticipation of the July 2018 changes.

The future of Division 7A

Andrew Noolan CTA

In the 2016 Federal Budget papers, Government set out that there would be changes to Division 7A that will apply from 1 July 2018. The purpose of discussing them here is to speculate on how the changes might alter the way that Division 7A needs to be dealt with, and, in one case, to identify what action might need to be taken prior to 1 July 2018 in preparation for the potential changes. Note that I have no specific knowledge on what the changes will be or how the changes will be implemented.

These changes are outlined on page 42 of the 2016-17 Budget’s Budget Measures Budget Paper No. 2, under the section ‘Ten Year Enterprise Tax Plan — targeted amendments to Division 7A’.

The 2016 Budget also contained the measure dealing with reducing the corporate tax rate over time, that found expression in the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 which passed through Parliament on 9 May 2017. While it was necessary for the tax rate changes to be introduced early, given for small business entities the tax rate changes apply from 1 July 2016, it is regrettable that we have not yet seen consultative material or draft legislation on the Division 7A changes. It is, however, possible that confidential consultation has been going on.

In addition to the summary above, the Budget Fact Sheet No 4 ‘Less Red Tape for Business’ set out the following:

Some tax rules are complex and difficult to apply, imposing unnecessary red tape and cost on business.

One particularly complex set of tax rules is Division 7A of Part III of the Income Tax Assessment Act 1936. This Division contains detailed rules to determine what kinds of benefits to shareholders and their associates are treated like unfranked dividends and therefore subject to personal income tax without any credit for company tax paid.

Breaches of these complex rules result in additional tax being imposed on income distributed by businesses.

The details

The Coalition Government believes that it should be as easy as possible for businesses to comply with the regulations and laws that apply to them.

For this reason the Government will work with stakeholders to develop targeted changes to simplify Division 7A and make it easier to understand and apply. Subject to the outcomes of consultation, the Government will amend these rules to include:

  • a self-correction mechanism providing taxpayers whose arrangements have inadvertently triggered Division 7A with the opportunity to voluntarily correct their arrangements without penalty;
  • new safe harbour rules, such as for use of assets, to provide certainty and simplify compliance for taxpayers;
  • amended rules, with appropriate transitional arrangements, regarding complying Division 7A loans, including having a single compliant loan duration of ten years and better aligning calculation of the minimum interest rate with commercial transactions; and 
  • technical amendments to improve the overall operation of Division 7A.

These changes will mean less red tape, greater certainty, improved integrity and more time for businesses trying to do the right thing to get on with actually doing business.

The changes are expected to commence from 1 July 2018.

Budget impact

This measure has an unquantifiable cost to revenue.

The Board of Taxation’s Post-Implementation Review included a number of other recommendations, but from the above it is not clear which recommendations will be adopted, and in what way. In particular, it is not clear whether the Board’s recommendation that the treatment of UPEs be simplified, with pre and post-2009 UPEs becoming 10 year loans, and that the ‘business income election’ be adopted for trusts, will be accepted. The business income election would allow a trustee to distribute to a corporate beneficiary without Division 7A applying if they agree to forego the CGT discount on pre-existing assets that are not goodwill or assets inherently connected with a business carried on by the trustee.

Self-correction mechanism

The Board recognised, in their second discussion paper, that the current mechanism allowing relief from the effect of Division 7A under section 109RB involves excessive compliance costs for taxpayers.

One of their recommendations was that there be a self-corrective action that allows putting complying loan agreements in place and making catch up payments of principal and interest. They also suggested that self-correction should only be available where, on the basis of objective factors, the breach that triggered Division 7A was unintentional and that voluntary corrective action be prima facie evidence that the original breach of Division 7A was unintentional.

They also recommended that, in the case of corrective action, there be a shortfall penalty of 25% where the breach was from failure to take reasonable care, but only 5% where the self-correction was made voluntarily.

Another part of the self-correction commentary by the Board recommended that the decision not to allow a 109RB application should be subject to the objection and review procedures in Part IVC of the Taxation Administration Act 1953. It is entirely unclear whether Government intends to adopt this recommendation.

Safe harbour

The safe harbour rules recommended by the Board in relation to the use of assets. 

Currently, where a shareholder or associate of a shareholder uses an asset, there is the potential for that use to be treated as a payment for Division 7A purposes, subject to an otherwise deductible rule and certain other carve-outs. The Board recommended:
  • In relation to depreciating assets, that a rental charge could apply, as would occur under an operating lease. The amount to be paid would comprise an interest amount, a depreciation component and an amount for the relevant asset’s other operating costs; and
  • For appreciating assets such as land and buildings, a usage charge could apply, calculated by multiplying the statutory interest rate by the asset’s indexed value, which could be updated with an arm’s length valuation every five years. The usage charge could also include an amount representing the relevant asset’s other operating costs.

Amended rules

The Board’s recommendation for the amendment of the Division 7A rules was to have only 10-year loans, at the RBA indicator lending rate for a small business – variable – other – overdraft rate for the month of May immediately before the start of the year in which the loan is made. This rate would then apply for the term of the loan.

There would be no need for a formal written loan agreement, merely written or electronic evidence by the lodgement day that the loan was entered into.

There would then be prescribed maximum loan balances during the term, which would include accumulated interest, so that the loan balance would be at most:

  • 75% of the original loan by the end of year 3;
  • 55% of the original loan by the end of year 5;
  • 25% of the original loan by the end of year 8; and
  • 0% at the end of year 10.
There would be no specified annual repayments subject to the above requirements for minimum balances being correct.

Interest would then be able to be accrued annually, but would need to be paid by the end of years 3, 5, 8 and 10.

The Board made additional recommendations and it is not clear whether they will be picked up along with the 10-year term:
  • That where a payment has not been declared as a deemed dividend it be treated as a loan, so that later deemed dividends can arise;
  • That deemed dividends where milestone payments are not met (at years 3, 5, 8 and 10) be the amount of the shortfall in the required balance, with interest calculated at the statutory rate, less amounts assessed as deemed dividends in earlier years.
  • That the ATO period of review for payments commence at the date of lodgement for an income year in which each milestone payment is required.
  • That there be administrative guidance on what constitutes acceptable evidence that a loan was entered into by the lodgement date, presumably in the absence of there needing to be a complying loan agreement.

Transitional rules

The Board recommended, in addition to the 10-year loan terms noted above, that there be transitional arrangements put in place to bring all loans, excepting 25-year loans, onto 10-year footing.

This would involve:
  • Grandfathering existing 25-year loans;
  • Bringing all pre-4/12/97 loans onto 10-year terms from the time of the application of the new provisions;
  • Extending the term of existing 7-year loans to 10-years; and
  • where the Commissioner is out of time to assess a deemed dividend arising from a payment, the rules should stipulate that the taxpayer is prevented from asserting that the payment was not made in the context of a loan.
There are two action points that come out of the above list, should it be adopted by Parliament:

  1. Ensuring that any current 7-year loans that might be refinanced to be 25-year loans are refinanced as soon as possible. This is in case it is decided at the time the new draft legislation is introduced Parliament decides not to grandfather 25-year loans after this date.
  2. Considering the implications of forgiving amounts recorded as pre-4 December 1997 loans so that they will not be required to be repaid in future.
In relation to pre-4 December 1997 loans, it should be noted that the ATO issued a Practice Statement in 2006, PSLA 2006/2(GA), where they set out that the ATO will not take ‘active compliance action’ in relation to determining whether pre-4 December 1997 loans should have resulted in deemed dividends because they became statute barred at some point and were therefore required to be accounted for as deemed dividends under section 109F(3).

If it turns out that the debt has become statute barred at an earlier point, then it would be prudent to write it out of the accounts of the company to prevent it potentially becoming necessary to put the loan on 10-year terms. The Commissioner also considers in the Practice Statement that a loan that has been refreshed outside of the statute period (which cannot happen in NSW) does not result in there being a new loan that is subject to Division 7A.

Despite the Board’s recommendation that pre-4 December 1997 amounts be brought under 10-year loan terms, that a debt that has become statute barred in NSW cannot be legally recovered means I would suggest, that it cannot be made subject to a 10-year term. This issue will no doubt be raised during the consultation phase.

If the decision is made to write a pre-4 December 1997 loan out of a company’s accounts regard would need to be had (particularly if the amount was not statute barred in a period that is not out of time for amendment) as to whether there are other implications of the amount being forgiven to the borrower such as:
  • Ordinary income being derived 
  • A fringe benefit being provided 
  • A capital gain arising 
  • Commercial debt forgiveness applying 
  • The value shifting rules applying.

The full paper is available for purchase on our website and is included with a subscription to the Tax Knowledge eXchange.


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