Background to Division 7A
Division 7A (“Div 7A”) is an integrity measure designed to assess a shareholder (or an associate of a shareholder) of a private company when they get access to company funds without declaring a dividend – in its simplest form the shareholder merely borrows the company’s excess cash funds. Broadly, Div 7A applies to payments, debt forgiveness or loans made to shareholders which have not been repaid to the private company by the lodgement date of the company’s relevant income tax return. Division 7A became law in 1997.
Back in November 2014 the Board of Taxation completed a post-implementation review of Div 7A and made 15 recommendations to the Government to simplify the operation of Div 7A and reduce compliance costs for taxpayers.
Consultation Paper released by Treasury
On 22 October 2018, Treasury released a Consultation Paper which sets out the Government’s proposed amendments with the aim of improving the operation of Div 7A and “making it easier for taxpayers to comply”. The proposed effective start date of the changes will be from 1 July 2019.
The proposed amendments in the Consultation Paper contain the biggest changes to Div 7A in 20 years and include changes that extend far beyond what the Board of Taxation recommended in 2014. If legislated in its current form, private company groups with any of the following will be impacted:
- Pre-1997 private company loans;
- Pre-December 2009 quarantined Unpaid Present Entitlements (“UPEs”);
- Post-December 2009 UPEs that have been put on sub-trust arrangements;
- 25-year Div 7A secured loans; and
- 7-year Div 7A unsecured loans.
Whilst draft legislation is still being developed following completion of the consultation process at the end of last year, it is expected that most of the proposed changes will be passed into law with effect from 1 July 2019. It will therefore be critical for affected taxpayers to plan for and establish a strategy to manage any potential consequences of the proposed amendments as early as possible.
Summary of proposed amendments
We provide a comparison summary of the key proposed amendments with the current law in the table below:
|Key proposed amendments||Current law||Proposed new law|
|Single 10-year loan model||o Maximum term of 7 years unsecured loan or 25 years secured loan.
o Formal Div 7A loan agreement is required.
o Interest is calculated on a daily basis.
o Annual benchmark interest rate is the Housing loans; Banks; Variable; Standard; Owner-occupier rate Lending rate published by the RBA prior to the start of each income year (currently at 5.20% for FY2018/19).
|o Single loan model with a maximum term of 10 years.
o No formal written loan agreement is required, however, written or electronic evidence showing that the loan was entered into must exist by the lodgement day of the company tax return.
o Interest is calculated for the full income year regardless of when the repayment is made or when the loan is entered into.
o Annual benchmark interest rate will be the Small business; Variable; Other; Overdraft – Indicator Lending rate published by the RBA prior to the start of each income year. This will be at higher interest rates than under current law (currently at 8.30% for FY2018/19).
|Transitional rules||o Outstanding 7 year Div7A loans – Retain their existing outstanding term but apply the new benchmark interest rate from 1 July 2019.
o Outstanding 25 year Div7A loans – If a complying 25 year Division 7A loan remains in existence as at 30 June 2021, the outstanding value of the loan will give rise to a deemed dividend unless a complying loan agreement with a maximum 10 year term is put in place by the lodgement day of FY2021 company tax return .
Example: A company has a $2.5m existing 25 year secured loan with a $2m outstanding loan balance as at 30 June 2021 that remains unpaid. The company will need to put in place a new 10 year complying loan arrangement for the $2m outstanding amount by the lodgement day of the company’s 2020/21 tax return.
o Outstanding Pre-1997 Loans – If an outstanding pre-1997 loan remains in existence as at 30 June 2021, the outstanding value of the loan will give rise to a deemed dividend unless a complying loan agreement with a maximum 10 year term is put in place by the lodgement day of FY2021 company tax return .
Example: A company has a $1m pre-1997 loan with a $1m outstanding loan balance as at 30 June 2021 that remains unpaid. The company will need to put in place a new 10 year complying loan arrangement for the $1m outstanding amount by the lodgement day of the company’s 2020/21 tax return.
|Distributable surplus concept will be removed||o The amount of a dividend that a private company can be deemed by Div 7A to pay cannot exceed the company’s distributable surplus.
|o The distributable surplus concept will be removed which means that the entire debit loan can be a deemed dividend even if the company does not derive any profits.
|Unpaid present entitlements (“UPE”)||o UPEs arising before 16 December 2009 are quarantined and are not subject to Div 7A.
o UPEs arising from 16 December 2009 are required to have a sub-trust arrangement put in place by the lodgement day or a Div 7A compliant loan agreement entered into before the company’s lodgement day of the next year tax return.
|o UPEs arising before 16 December 2009 are currently in consultation. Further updates will be provided when we have more clarity.
o UPEs arising from 16 December 2009 to 30 June 2019 (i.e. sub-trust arrangements) will need to be put on complying Div 7A loan terms under the new 10-year loan model by 30 June 2020 with the first repayment due in the 2020 income year.
o UPEs arising from 1 July 2019 onwards will need to be either paid to the private company or put on complying Div 7A loan terms under the new 10-year loan model prior to the lodgement day of the company tax return.
|Self-correction mechanism||o If a taxpayer inadvertently breaches Div 7A requirements (e.g. fails to enter into a complying loan by lodgement day), they can correct the mistake by applying to the ATO for discretion to disregard the deemed dividend and have it franked (This is known as a 109RB application).
o The process of applying for the discretion imposes significant compliance costs on the taxpayer.
|o Under the proposed amendments, if certain eligibility criteria are met then a taxpayer can self-correct the mistake by:
i. Converting the benefit into a complying loan agreement (with the same term as it should have been); and
ii. Make catch-up payments of the principal and interest (presumably this means by cash repayment or unfranked dividend).
o However, a 109RB application is still required if you wish to apply for the ATO’s discretion to frank the dividend.
|Extension of amendment period||o Subject to 2-year (for most SBE business) or 4-year amendment period (for non-SBE business).||o Extend the amendment period to 14 years for Div 7A purposes.
o We note that only cases involving fraud or evasion generally have an amendment period exceeding 4 years.
|Safe harbour rule||o Where an asset is provided for use by a company to a shareholder (or their associates), the amount of the deemed dividend is the amount that would have been paid for the provision of the asset by parties dealing at arm’s length less any consideration paid.
o The determination of this arm’s length amount can be difficult to ascertain.
|o This safe harbour rule is designed to assist taxpayer in determining the arm’s length value of the assets for Div 7A purposes.
o The formula for the safe harbour is:
(Value of asset at 30 June x Benchmark interest rate plus 5% uplift) x days for private use
days in a year
o For example, Company A owns a yacht valued at $1.2m which has been used by friends for once every month. The benchmark interest rate for the income year is 8.5%. Then the deemed dividend for the income year will be:
$1.2m x (8.5% + 5%) x 12 days / 365 days
We are closely monitoring the status of the proposed changes to Div 7A as it progresses to draft legislation. If you wish to discuss any aspect of this Client Alert please contact your Director.
This material is general commentary only. None of the material is, or should be regarded as, personal or financial product advice. Accordingly, no person should rely on any of the contents of this publication without first obtaining specific advice from Hill Rogers. Every effort has been made to ensure that the content is accurate, however it is not intended to be a complete description of the matters described. Hill Rogers, its Principals and agents accept no responsibility to any person who acts or relies in any way on any of the material without first obtaining such specific advice.