Waking up from the Div 7A nightmare
Division 7A of the Tax Act has been described as a “Nightmare on Elm Street”. Its basic aim is to act as an anti-avoidance measure to prevent corporate businesses distributing profits tax-free to owners by way of disguised dividends. The ad hoc and piecemeal approach to fixing specific concerns with this division over many years has created a highly complex body of law that many practitioners fail to fully comprehend. Hence its association with the famous 1984 horror movie: it lurks, waiting for unsuspecting taxpayers to fall into its many traps.
The announcement that the Federal Government has requested the Board of Taxation (BOT) to undertake a post-implementation review of Division 7A provides a ray of light. The IPA has long advocated in its pre-Budget submissions for such a review and wholeheartedly supports the BOT’s involvement.
Division 7A represents one of the more commonly encountered problem areas for practitioners dealing with small businesses. Just the high compliance and administrative costs alone are enough to warrant a review of its provisions.
Business owners grapple with its meaning, resulting in frequent and unintended breaches, despite the efforts of practitioners trying to explain its impacts.
The ATO’s changed view of the retention on trust of an unpaid present entitlement (UPE) has added to the complexity by introducing intricate interactions between the legislative provisions and certain ATO rulings and administrative determinations. Bringing UPEs to corporate beneficiaries into the Division 7A net has also significantly increased compliance costs for small businesses using trust structures.
The main points included in our submission to the BOT to improve the operation of Division 7A can be summarised as follows:
The Division 7A provisions of the Income Tax Assessment Act 1997 (the Tax Act) should be rewritten in a clearer and simpler manner to minimise the compliance burden. The policy intent of ensuring that companies do not make tax-free distributions to shareholders can still be maintained while the provisions are cleansed of technical/interpretative difficulties and uncertainties.
Unpaid present entitlements
As a matter of policy, the rewrite should address the uncertainty surrounding whether UPEs in favour of corporate beneficiaries should be considered loans for Division 7A purposes.
This is particularly important since the release of Taxation Ruling TR 2010/3, which sets out the Commissioner’s view on when a private company with an unpaid entitlement from an associated trust is considered to have made a loan for Division 7A purposes. This ruling effectively brings UPEs to corporate beneficiaries into the Division 7A net and turns them
into deemed dividends unless corrective action is taken. This is achieved by extending the definition of a loan to include financial accommodation.
Trusts have been a longstanding and legitimate structure chosen by many families and businesses, principally for asset protection and flexibility. UPEs have been in existence for many years. The overwhelming view (and policy objective) was that UPEs were not loans as long as the money stayed within the trust for commercial purposes – and that in the event that the trust lent the money to a shareholder or their associate, then Subdivisions EA and EB of Division 7A would apply in the manner in which they were originally intended.
The IPA’s preferred policy position is that the retention of funds within a group should not be subject to Division 7A. A loan from a private company to a trust within the private group, where the funds do not permanently leave the group for private use or consumption and are used as working capital or for investment in the business (excluding passive investment), should be excluded from Division 7A.
If the Government’s policy intent is to extend Division 7A to UPEs, it needs to consider more commercially acceptable options with respect to repayment of loans than are currently available under ATO administrative guidance.
UPEs and loan repayments
In the event that UPEs in favour of corporate beneficiaries are to be considered loans for Division 7A purposes, there should be no obligation for loan repayments.
Ideally, we would prefer that such loans not incur interest obligations unless the UPE funds were not used entirely for income-producing purposes by applying an ‘otherwise deductibility’ rule.
Alternatively, loans with no repayments could be interest-bearing, with interest charged at a rate that is fixed from time to time by regulation (on a similar basis as Division 7A-compliant loans). The entity borrowing the funds would be subject to the ordinary interest deductibility rules. This would ensure that funds retained in the family group for working capital purposes would be able to claim an interest deduction for any interest incurred.
If the funds were used wholly or partially for private purposes, then deductibility would be denied or apportioned accordingly. If such funds left the group, then Division 7A would apply in accordance with its policy intent (currently, Subdivision EA and EB would catch such amounts as deemed dividends).
In the event that Division 7A is triggered and amounts are treated as deemed dividends, there appears to be no reason why such amounts should not be allowed
to carry franking credits.
The automatic franking of deemed dividends would ensure that such distributions would only be subject to top-up tax. This would alleviate the need to apply for the commissioner’s discretion to treat such amounts as frankable distributions. (The Commissioner has a relieving discretion for honest or inadvertent omission.)
The existing penalty regime would still apply to act as a deterrent to false and misleading statements and to any failure to exercise reasonable care. The Commissioner’s discretion is complex to administer and relies on interpretations that lead to disagreements between various parties when they apply for the discretion.
Statutory interest model
With respect to the three reform options put forward in the discussion paper on the BOT review, the statutory interest model appeals most. This model allows for funds to be retained internally within private groups without the need to repay principal at any point in time. The distribution model is too complex and the adjustment model is unlikely to be able to significantly simplify the law.
Waking up from the bad dream
The IPA has a small business focus, and the cost of complying with the provisions contained in Division 7A is of major concern to our members servicing small business clients. At the time of writing, we were waiting for the BOT’s findings and recommendations on their post-implementation review of Division 7A. Their report was to be provided to Government by 30 June 2013. It will serve as an indicator of possible reform pathways for Division 7A. With luck, we may wake up from our bad dream.