Tucked away in this year’s Budget papers was an announcement that the Government will make targeted amendments to Division 7A. There is very limited detail in the announcement.
While the amendments are stated to apply from 1 July 2018, we fear the lack of detail – in what is an election year Budget – may be a sign they will be highly retrospective in nature. We are particularly concerned about whether it is a sign that pre-1997 loans and pre-2009 UPEs will become subject to complying loan repayment requirements.
The Budget announcement states the amendments will be aimed at easing taxpayer compliance, including:
- introducing a self-correction for inadvertent breaches;
- safe-harbour rules to provide certainty;
- simplified Division 7A compliant loan arrangements; and
- some technical amendments.
The Budget papers state the amendments draw on some recommendations made by the Board of Taxation in its Post-implementation Review. At this stage there is very little detail provided. However, if we look back at the Board’s recommendations, we might find some insight.
Board of Taxation’s recommendations
The Board recommended improving Div 7A using four guiding principles. The four principles are that amendments to Div 7A should:
- ensure private use of company profits attracts tax at the user’s personal tax rates;
- remove impediments to investment of business income as working capital;
- maximise simplicity; and
- not advantage the accumulation of passive investments funded by profits taxed at the company tax rate.
The Board has developed an ‘Amortisation Model’ to achieve all 4 principles. Under this model, complying loans would be excluded from triggering deemed dividends. Complying loans would have the following features:
- repayable over 10 years (with no choice of 7 or 25 year loans or sub-trust arrangements);
- reduced documentary requirements (just need written/electronic evidence by lodgement date);
- flexibility in when interest and principal repayments are required. Rather than adopting the current system of minimum annual repayments, the proposed model would prescribe maximum balances by the end of each of years three, five, eight and 10. Those balances would be 75%, 55%, 25% and 0% respectively.
- the required rate of interest would be based on the RBA rate for ‘small business; variable; other; overdraft’ for the previous month of May. This is considerably higher than current Div 7A rate. For instance, in the current year ending 30 June 2016, the Board’s recommended rate would be 8.45% compared with the current Division 7A rate of 5.45%.
Transitional rules would apply to ensure existing 25 year loans would be grandfathered and continue to operate over their remaining 25 year terms.
However, the proposal appears to be that all other existing complying Div 7A loans would automatically convert to 10 year terms, coupled with the new higher interest rates and more flexible repayment dates.
Of great significance, all pre-1997 loans and pre-2009 UPEs would become new complying 10 year loans starting from the application date of the new provisions. This would mean they must be repaid, with interest, over 10 years.
It remains to be seen what effect, if any, this would have on pre-1997 loans that have already become statute barred and, therefore, already technically triggered the operation of Division 7A, even if the taxpayers have not brought the deemed dividends into their assessable income.
Could this be what the Budget paper is contemplating when it refers to ‘simplified Division 7A loan arrangements’? If so, it will likely be deeply unpopular; at least in the case of pre-1997 loans and pre-2009 UPEs.
A safe harbour for trusts?
Under the Board’s proposed Amortisation Model, trusts would be able to make an election to ensure UPEs owed to companies are not subject to Division 7A. This reflects the second principle of removing impediments to investment of business income as working capital.
However, a result of making the election would be that the trust would not be able to access the 50% CGT discount on the disposal of any assets other than goodwill and intangible assets inherently connected with the trust’s business, regardless of when the assets were acquired by the trust. This reflects the fourth principle that Division 7A should not advantage the accumulation of passive investments funded by profits taxed at the company rate.
We think this would prove attractive to the many trusts that rely on profits being taxed at the corporate rate to fund their business and who’s only appreciating assets consist of goodwill and IP used in the business.
We are left wondering if this is what the Government has in mind when it refers to ‘safe-harbour rules to provide certainty’.
Interest only model
The Board acknowledged that the fourth of its 4 principles has not met with universal acceptance during its discussions with stakeholders. As such, it raised the prospect of an alternative model which only adheres to the first 3 principles. The alternative is the ‘Interest Only Model’.
The Board considered the Interest Only Model is likely to be costly to the revenue as it promotes the accumulation of passive investments in individuals or trusts hands (with access to the 50% CGT discount) funded by profits taxed at the company rate. In addition, the interest would ultimately be deductible (if the ordinary tests for deduction are met) at individual marginal tax rates but assessable at the company tax rate. This could lead to arbitrage opportunities; particularly as the gap between the corporate rate and individual marginal rates expands.
Other recommendations by the Board included:
- adopting a self-correction mechanism for unintentional breaches of Division 7A, rather than imposing the compliance and administrative costs of the current section 109RB discretion. This is referred to in the Budget papers; and
- deemed dividends should be frankable to remove double penalty that currently arises. That is, Division 7A already penalises taxpayers for a breach by including a dividend in their assessable income.