The Treasury has on 22 October 2018 released draft paper for consultation to the Government’s proposed amendments to private company distributions (‘Division 7A’). These amendments incorporate the Government’s response on the findings and recommendations of the Board of Taxation in their final report on the ‘Post implementation Review of Division 7A of the Part III of the Income Tax Assessment Act 1936’. The proposed amendments will commence from 1 July 2019.
The Government is of the view that its response makes a number of enhancements to Division 7A. The amendments will include:
- simplified Division 7A loan rules to make it easier for taxpayers to comply;
- a self-correction mechanism to assist taxpayers to promptly rectify breaches of Division 7A;
- safe harbour rules for the use of assets to provide certainty and simplify compliance for taxpayers;
- technical amendments to improve the integrity and operation of Division 7A while providing increased certainty for taxpayers; and
- clarification that unpaid present entitlements (UPEs) come within the scope of Division 7A.
We will explore some of the amendments below.
How will the enhancements become apocalyptic?
Division 7A rules, which commenced on 4 December 1997, ensure that disguised and informal distributions of private company profits are subject to tax instead of being tax free benefits. The three key situations which can give rise to a taxable deemed dividend are when a private company:
- makes a payment;
- lends a loan; or
- forgive a debt
to its shareholders and associates.
At present, instead of being deemed taxable dividends in one single year, private company distributions that are made under a complying Division 7A loan agreement has either a 7 year (unsecured) or 25 year (secured) principal and interest (P&I) loans. The Government is now proposing to replace them with a single 10 year P&I loan term to ‘unwind’ the benefit. Instead of grandfathering existing Division 7A loans, they will also need to comply with the 10 year loan model. Specifically:
- 7 year loans in existence at 30 June 2019 – they must comply with the new 10 year loan model and new benchmark interest rate to remain complying loans, but will retain their existing outstanding term.
- 25 year loans in existence at 30 June 2019 – they will be exempt from most of the changes until 30 June 2021. However:
– the interest rate payable during this period must equal or exceed the new benchmark interest rate.
– on 30 June 2021, the outstanding loan balance will need to be put on a 10 year loan agreement prior to the lodgment day of the 2020/21 company tax return.
The first 10 year loan repayment will be due in the 2021/22 tax year.
How will the apocalypse be cometh?
Listed below are some of the proposed amendments which ‘extend’ the current reach of Division 7A rules.
1. Pre-1997 loans
At present, pre-4 December 1997 loans are ‘quarantined’ on the accounts of the company from the application of the Division 7A rules. The proposed amendments include pre-4 December 1997 private company loans from being brought under the 10 year loan term from 30 June 2021 if they remain unpaid. The first 10 year loan repayment will be due in the 2021/22 tax year.
2. Distributable surplus
At present, Division 7A only applies if there is a ‘distributable surplus’ in the company, ie, a notional company profit ‘cap’ in which the total amount of deemed dividends can only be taken to be paid out of profits to shareholders and associates.
The Government propose to remove this distributable surplus cap and that dividends can be deemed for the entire value of the benefit that was extracted from the private company to the shareholders or associates instead, ie, dividends can be paid out of both profits and capital as per Corporation Act.
3. Unpaid present entitlements
An Unpaid Present Entitlement (UPE) is an amount of trust income which the trustee of a trust appoints, but does not pay, to a private company beneficiary. At present the Australian Taxation Office views that UPEs are within the scope of Division 7A rules, unless the funds representing the UPEs are held for the sole benefit of the private company held under a separate sub-trust and put on a 7 or 10 year interest only loan term.
The Government propose all unpaid UPEs:
- arising on or after 16 December 2009 – will need to be on complying loans by 30 June 2020. The first P&I loan repayment will be due in the 2019/20 tax year;
- arising on or after 1 July 2019 – will need to be on the new 10 year loan prior to the private company’s lodgment day;
- that are already placed on complying 7 or 25 year Division 7A loan terms – will be treated as per the 10 year loan model transitional rules above.
- arising before 16 December 2009 – the Government is seeking feedback on whether they should be quarantined from Division 7A rules.
4. Provision of assets for use
Where there is a use of the private company’s assets by the shareholders or associates, the Government proposes to introduce a safe harbour formula and accompanying legislation to calculate the deemed dividend for the exclusive use of all assets excluding motor vehicles. Market rental value for motor vehicles can be readily ascertained by other means.
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).
5. 14 Year review period
The Government proposes to start from 1 July 2019, extending the Division 7A review period to 14 years after the end of the income year in which the loan, payment or debt forgiveness gave rise or would have given rise to a deemed dividend.
What to do with private company distributions?
Taxpayers with Division 7A loans and UPEs exposures or risks will need to review, restructure and to especially consider the cashflow implications of these proposed amendments. In its current form, the tax, business and cash impacts will be far reaching, if not apocalyptic for those unprepared and unplanned for the taxman cometh!
This article was co-authored by Bill Leung, HLB Mann Judd Melbourne