Introduction
The scope of Division 7A ITAA36 is being extended to catch the use of private company assets by a shareholder or their associate for less than market-value consideration.
From 1 July 2009, such arrangements may result in the user of the asset being deemed to have received an unfranked dividend from the company.
This article considers the scope of the new rules, together with potential planning strategies for affected taxpayers.
Section 109C
Under section 109C(1) ITAA36, a private company is deemed to pay a dividend if it makes a “payment” to a shareholder or their associate (subject to the distributable surplus limitation).
“Payment” is currently defined by section 109C(3) to mean the following:
- a payment to, on behalf of, or for, an entity;
- a credit to, on behalf of, or for, an entity; or
- a transfer of property to an entity.
Where a private company owns land which is leased to a shareholder or their associate, the lessee receives a property interest in the land. This constitutes a “transfer of property”, which is therefore treated as a payment to the lessee for Division 7A purposes. Where the lease is granted for less than market-value consideration, a deemed dividend may therefore result.
However, where:
- the company permits the shareholder or their associate to use the land under a right-to-use, or licence; or
- the asset in question is a chattel, rather than land,
then under the existing rules, the use of the asset by the other entity would not constitute a “payment” to the entity, even where it is for less than market-value consideration.
This has allowed private companies to purchase “lifestyle” assets (such as cars, boats and holiday homes), which are then made available for use by shareholders or their associates, without invoking the operation of Division 7A. Where there is no nexus between the use of the asset and employment, the arrangement may also fall outside the scope of fringe benefits tax.
As the income of the company used to purchase the asset has only been taxed at 30%, this outcome has been viewed by the government as undermining the integrity of Division 7A.
2009 Budget Press Release
In response to this perceived mischief, on 12 May 2009 the Federal Treasurer announced as part of the 2009/2010 budget that Division 7A would be extended to catch the use of private company assets by shareholders or their associates for less than market-value consideration.
Political Pressure - Farmers
Not long after the Treasurer’s announcement, political pressure began mounting against the government regarding the potential impact of these changes on farmers.
On 2 June 2009 the Senate Economics Legislation Committee heard evidence from ATO officers regarding the estimated budget impact of the proposed amendments. Senator Heffernan, of the Liberal Party, highlighted concerns that the amendments may cause undue hardship for farming families where farmland is owned by a company and made available for use by individuals in the conduct of their farming activities.
Carve-outs - "Otherwise Deductible" and "Residence" Exceptions
In response to lobbying from the primary production sector and others, on 14 September 2009 the Federal Assistant Treasurer announced that the amendments to section 109C would include two exceptions:
- an “otherwise deductible” rule; and
- a “residence exemption”, whereby a residence that is an integral part of business real property owned by a private company but is lived in by a shareholder or their associate as part of carrying on business by them is disregarded from the revised definition of “payment”.
Exposure Draft Legislation
On 4 January 2010, exposure draft legislation to implement the changes was released by the Treasury. The exposure draft provisions propose to amend section 109C by adding an additional category of “payment” as follows:
- a grant of a lease, or a licence or other right to use an asset, to an entity (other than a transfer of property to the entity).
The amount of such a deemed payment is proposed to be the notional arm’s length consideration for the lease, licence or right to use the asset, less any consideration actually given. Where the actual consideration equals the arm’s length amount, the amount of the deemed payment will be nil.
The “otherwise deductible” rule is proposed to apply where expenditure in respect of the use of the asset, if paid, would give rise to a once-off deduction (i.e. not a depreciation deduction). In applying this test, the rules regarding self-education expenses (section 82A ITAA36) and car expenses (Division 28 ITAA97) are proposed to be ignored.
The requirements of the “residence exemption” are proposed to be as follows:
- the asset in question must be a dwelling;
- the user of the dwelling must carry on a business;
- the user of the dwelling must have been granted a lease, licence or other usage right in respect of land, water or a building by the company for the primary purpose of enabling the carrying on of that business; and
- the dwelling must comprise no more than 10% of the total area of the land, water or building that is subject to the lease, licence or other usage right.
An additional “minor-use” carve-out has also been included in the exposure draft legislation. This is proposed to cover the use of an asset where that usage right would, if provided in an employment context, constitute a minor benefit for FBT purposes (i.e. certain benefits having a notional taxable value of less than $300).
Planning Consequences
The mischief to which these amendments are directed is most likely to concern assets that decline in value. This is because there is a significant disadvantage to acquiring an appreciating asset (such as a holiday home) in a private company, namely that the 50% CGT discount will not be available if the asset is later sold for a gain. As a result, the strategy has historically made the most sense in relation to wasting assets such as cars, boats or other lifestyle “toys”.
Restructuring for Cars, etc.
Where a wasting asset is currently owned by a private company for use by its shareholder or their associate, it will probably be unattractive for the user to start paying market-value consideration for the use of the asset. This is because market rate for the hire of such an asset tends to be high in relation to the value of the asset.
A more attractive solution may therefore be for the private company to sell the asset to a related entity (such as an individual, or the trustee of a trust) at its current market value. The purchaser could then use, or make the asset available for use by the desired parties, for no consideration, without invoking Division 7A.
Where the purchaser lacks the funds to pay for this purchase, the sale could be funded by way of a Division 7A loan made by the private company. However, this will result in the need to make ongoing principal-and-interest repayments to the company.
A more permanent solution would be for the company to declare a franked dividend, which would then be used to fund the asset purchase. However, this may result in a tax liability to the shareholder in respect of the dividend. This might be mitigated by spreading the dividend over more than one income year.
The sale of such a wasting asset by a private company for market value would often not result in any income tax or CGT consequence. No balancing adjustment should happen where the asset has not been depreciated by the company for income tax purposes (i.e. where it has not been used for any taxable purpose).
Also, where asset constitutes a “personal use asset” for CGT purposes (i.e. an asset used mainly for the personal use or enjoyment of an associate of the company), any capital loss on the sale of the asset would be disregarded under section 108-20 ITAA97.
Restructuring for Holiday Homes
Where the asset in question is a holiday home or similar real property, arranging for the company to dispose of the asset to a related party may be less attractive.
Any capital gain on the disposal of the property would be subject to tax (the exemption for personal use assets does not apply to land). Also, the transfer of the property will trigger a stamp duty liability for the transferee.
It may therefore be preferable to begin charging arm’s length consideration to the company’s shareholders and their associates for their use of the property. If the relevant individuals lack the funds to pay this amount, it could be funded by way of a Division 7A loan made by the private company, or a franked dividend.
Future Asset Acquisitions
Where future lifestyle assets are to be funded from the profits of a private company, the preferred approach (in the absence of declaring a franked dividend) may be for the company to make a Division 7A loan to a related entity (such as the trustee of a trust). The trustee could then make the asset available for use by the desired parties for no consideration, without invoking Division 7A.
Conclusion
The exposure draft legislation also includes other provisions designed to close existing “loopholes” in relation to Division 7A. When viewed in their entirety, the message conveyed by these proposed amendments is clear. The funding of lifestyle expenditure out of income that has been sheltered from tax at the corporate rate is effectively over.