Division 7A loans
Division 7A of the Income Tax Assessment Act 1936 (Cth) contains anti-avoidance measures designed to prevent private companies from making tax-free distributions of profits to shareholders or to their associates in the form of payments, loans or debts that are then subsequently forgiven by the company.
Division 7A rules are complex, inflexible, and impose significant compliance costs on taxpayers, who may not be aware of the impact or operation of the rules.
Reform by media
Following the report completed by the Board of Taxation in late 2014, the Federal Government announced in both the 2016/2017 and 2018/2019 budget that reform to Division 7A would be completed. The much anticipated reforms to Division 7A are expected to be implemented from 1 July 2019. This date has not been extended at this stage.
With no draft legislative amendments released by the Federal Government this is a situation of reform by media in which we must anticipate Division 7A reforms in readiness for 1 July 2019 based on media releases. This creates uncertainty in the impact that the reform may have on taxpayers, particularly those who may suffer cash flow consequences as a result of the loan repayment rule changes contemplated in the reform.
What will be included in the 1 July 2019 Division 7A reform?
The Federal Government has announced that the Division 7A reform is intended to make Division 7A simpler and easier to comply with.
Major changes proposed to Division 7A include the following:-
- Currently, the value of the company benefit is converted to a loan if it meets the complying loan requirements (being a written loan agreement with a maximum 7 year loan term for unsecured loans or 25 years for secured loans, has the minimum interest rate and the benefit is not taxed as an unfranked dividend in the hands of the recipient in that income year). The current benchmark interest rate is the bank variable housing loan interest rate. If the minimum yearly repayments are not completed then the shortfall is taxed as a dividend. The reform proposes to amend this so that:
- there is no requirement for a written loan agreement (although there must still be evidence of an intention to enter into a loan arrangement and the operative terms clearly identifiable);
- the benchmark interest rate increases to an overdraft rate (based on current interest rates would result in an increased interest rate from around 5% to 8%); and
- the maximum loan term is 10 years (removing both the 7 and 25 year current loan terms).
- There is intended to be inclusion of a self-correction mechanism to assist taxpayers to promptly rectify breaches of Division 7A. This will include the ability of the taxpayer to convert the benefit into a complying loan agreement on the same terms that would have been applied had the loan agreement been entered into when it should have. This would mean that ‘catch-up’ payments may need to be completed.
- The application of pre-1997 loans will be varied. Currently, loans advanced prior to 4 December 1997 (i.e. loans which pre-date the implementation of Division 7A) are not governed by Division 7A (subject to certain exception, such as a variation to the loan amount). These loans are typically frozen on the balance sheets. Under the reform, these pre-1997 loans will be taken to be financial accommodation at 30 June 2021 and a deemed dividend unless converted to a 10-year loan before the lodgement of the 2021 tax return. This could have an adverse effect on borrowings and require assets to be realised.
- Where a trust makes a company entitled to a share of its income for a year, and the amount remains unpaid it gives rise to an unpaid present entitlement (UPE). The UPE may remain unpaid if the trust does not have sufficient cash to discharge the amount payable. A UPE is a form of financial accommodation and falls within the extended definition of a loan unless the funds representing the UPE are held for the sole benefit of the private company (Taxation Ruling 2010/3). The options to hold the funds representing the UPE are for the sole benefit of the company include establishing a separate trust that lends the amount of the UPE to the trust for 7 or 10 years on interest only terms or invests the amount in a specific income-producing asset. Trusts are not required to repay the amount representing the UPE until the conclusion of the interest-only loan. Under the Division 7A reform, UPE’s to private companies will be deemed loans. This means that the UPE will have to be repaid to the private company over time as a complying loan or will be subject to tax as a dividend.
- At present, the period in which the ATO may amend a tax return to account for a deemed dividend is limited to the amendment periods i.e. either 2 or 4 years (unless there is fraud or evasion). The Division 7A reform will increase this assessment review period to 14 years.
- It is proposed that new safe harbour rules apply unless the taxpayer has received a non-exclusive right to use an asset. They will apply for the exclusive use of all assets except motor vehicles (noting that the market value for rental of a motor vehicle is ascertainable by other means).
- Currently, Division 7A does not apply to loans made in the ordinary course of business if the loan is at arm’s length (certain rules apply to this). Under the Division 7A reform, this would be amended so that Division 7A will only not apply if the loan made in the ordinary course of business is also a loan with a third party lender.
There is still considerable uncertainty. For example, would occur in the event of early repayments within the new 10 year loan period? Does interest remain calculated at the opening balance each year etc.?
We are also what transitional rules may be implemented as part of the Division 7A reform, other than the following:-
- all existing 7 year loans must comply with the new rules from 1 July 2019;
- 25 year secured loans will be subject to the new riles in 2 stages:-
- The interest rate must be equal to or higher than the new overdraft rate;
- The outstanding value of the loan must be converted to a 10 year loan prior to the lodgement of the 2020/21 tax return, with the first repayment due in the 2021/22 income year.
Given the close proximity of 1 July 2019, we can only hope that the draft legislative changes to Division 7A are released by the Federal Government in the near future.