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The Board of Taxation: discussion paper on the review of Division 7A

PwC Australia

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Australia April 1 2014

On 25 March 2014, the Board of Taxation (BoT) released a second discussion paper from the Post Implementation Review of Division 7A of the Income Tax Assessment Act 1936. The Review was initially requested by Government on 18 May 2012, and the terms of reference for the Review were extended on 8 November 2013, and the deadline for finalising the Review extended to 31 October 2014. The extension of the terms of reference followed the BOT's initial finding that much of the complexity and difficulty in relation to Division 7A related to its interaction with other areas of the tax law, including the trust income provisions in the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). 

Under the extended terms of reference, which acknowledge 

that Division 7A is part of a 

broader tax framework in which 

private business structures 

operate, the BoT was requested: 

 to examine the broader 

taxation framework in 

which Division 7A operates 

including its interaction 

with other areas of the tax 

law;  

 to examine whether there 

are any problems with the 

current operation of 

Division 7A, that are 

producing unintended 

outcomes or 

disproportionate 

compliance and 

administration costs; and  

 to the extent that there are 

problems, recommend 

options for resolving them 

so that, having regard to the 

policy intent of Division 7A 

and potential compliance 

and administration costs, 

the tax law operates 

effectively. 

Whilst under these extended 

terms of reference, the BoT is no 

longer restricted to a 'revenue 

neutral' or 'near revenue 

neutral' outcome, the terms of 

reference provide that the BoT 

should take account of the 

revenue implications of various 

options and, where appropriate, 

suggest approaches that 

minimise any revenue cost.

The BoT's first discussion paper 

was released in December 2012, 

and raised for consideration 

three mutually exclusive 

approaches to reforming 

Division 7A. The three 

approaches suggested by the 

BoT in the first discussion paper 

are: 

1. The Division 7A adjustment 

model: address the individual 

issues and problems in Division 

7A by way of specific legislative 

amendment. As a starting point, 

the matters outlined in Chapter 

4 of the first discussion paper 

would be considered to 

determine which of these should 

be addressed by legislative 

change.

2. The statutory interest model: 

largely replace Division 7A with 

a requirement that loans to 

related entities carry a statutory 

rate of interest, but with no 

requirement that principal be 

repaid prior to termination of 

the loan. 

3. The distribution model: allow 

the retention of profits within 

the private group for permitted 

purposes and to treat any profits 

not so used, and not distributed, 

as deemed dividends (which 

would be able to be franked). 

In raising these alternative 

approaches, the BoT made the 

further point that elements of 

Division 7A would be retained to 

a greater or lesser degree in all 

models and that in that sense, 

there is some overlap between 

the models, albeit, each 

alternative offers different 

advantages and disadvantages.

In the second discussion paper, 

which is the BoT's response to 

the extended terms of reference 

and which supplements the first 

discussion paper, the BoT 

concludes that in its current 

form, Division 7A fails in 

achieving its policy objectives 

and can be a significant source 

of compliance costs for business 

- even for those that operate in 

accordance with the policy 

intent of the provisions. 

Notably, the BoT states that in 

its current form, “Division 7A 

provides an inadequate 

response to the different ways 

private businesses are 

structured and fails to 

acknowledge the many tax and 

non-tax considerations that 

dictate those structures." In 

particular the BoT believes that 

given the use of trusts in 

structuring businesses of private 

groups, the interaction of 

Division 7A with trusts must be 

factored into any approach to 

reforming the current system. 

In making recommendations in 

the second discussion paper for 

the reform of Division 7A, the 

BoT states that “the high level 

tax policy aims of efficiency, 

simplicity and equity will be 

served by adopting a policy 

framework for private 

businesses that supports the 

progressivity of the personal tax 

system by striking an 

appropriate balance between 

the following four goals: 

 It should ensure that the 

private use of company 

profits attracts tax at the 

user’s progressive personal 

income tax rate.  

 It should remove 

impediments to the 

reinvestment of business 

income as working capital.  

 It should maximise 

simplicity by reducing the 

compliance burden on 

business and the 

administrative burden on 

the Commissioner and other 

stakeholders.  

 It should not advantage the 

accumulation of passive 

investments over the 

reinvestment of business 

profits in active business 

activities.”

Whilst the BoT canvasses the 

idea of taxing business profit 

accumulations at the company 

tax rate irrespective of the 

structure chosen, this idea is not 

considered in detail in the 

discussion paper since its 

consideration is outside the 

terms of reference for the 

Review. The BoT however 

considers that whilst a capped 

tax rate for business is ‘outside 

scope', there is scope within the 

terms of reference to consider 

whether there is a case for 

providing 'active trading trusts' 

with increased access to the 

corporate tax rate for profits 

used to finance their operations. 

With respect to 'progressivity of 

the tax system', the BoT 

expresses the view that such 

progressivity “should not be at 

the expense of impeding 

business to reinvest their 

income as working capital,"

since “this reinvestment 

supports improved productivity 

and entrepreneurial growth."

The BoT goes on to state that 

“by contrast, the private use of 

business income serves a 

different purposes, namely the 

enjoyment and accumulation of 

private wealth, in which case the 

progressivity of the personal 

income tax system needs to be 

preserved."

Consistent with the goals listed 

above, the second discussion 

paper outlines the following five 

reforms to improve the 

operation of Division 7A: 

1. A unified set of rules 

based on the principle 

of transfers of value 

From: A complex, 

unpredictable system that 

lacks a coherent set of 

guiding principles and leads 

to inconsistent treatment of 

cash-based transactions 

(loans, payments, debt 

forgiveness) and 

transactions involving the 

use of company assets. 

To: A single set of common 

principles for dealing with 

loans, payments, debt 

forgiveness and use of 

company assets. 

2. A better targeted 

framework for 

calculating a 

company’s profits

From: A system in which 

the rules for calculating 

company profits (or 

distributable surplus) are 

complex and costly 

(requiring regular 

revaluations of assets, 

formally or informally, 

where informal valuations 

may lead to disputes about 

the values) and can lead to 

either double taxation or an 

inappropriate failure to tax 

certain transactions. Under 

the current rules, 

distributable surplus is 

based on the values of 

assets. Valuing assets 

formally can involve 

significant costs to small 

businesses while informal 

valuations provide less 

certainty. 

To: A simpler system in 

which asset revaluations 

will not be required and 

unrealised profits will not 

be taken to be distributed 

because company assets 

have been used; and 

company profits will be 

tested each year to 

appropriately tax all 

transactions. 

3. A simpler, more flexible 

and better targeted 

system of ‘complying 

loans’

From: A system that is 

inflexible because it requires the principal on the 

loan to be repaid in equal 

annual instalments over the 

life of the loan; and a system 

that requires loan terms 

that are either too 

restrictive (that is, 7-year 

terms for unsecured loans) 

or too generous (25-year 

terms for loans secured by 

real property). 

To: A single 10-year loan 

period with more flexible 

requirements for the 

repayment of principal. 

4. Greater flexibility for 

trusts that reinvest 

unpaid present 

entitlements (UPEs) as 

working capital

From: A system that 

imposes significant 

complexity where trusts 

retain funds distributed to 

companies as working 

capital (including adhering 

to Australian Taxation 

Office ‘safe harbour’ 

arrangements). 

To: A ‘tick the box’ regime 

that will provide trading 

trusts with a simple option 

to retain funds that have 

been taxed at the corporate 

rate, providing important 

working capital. As a tradeoff, trading trusts that make 

this election will be denied 

the Capital Gains Tax 

discount (like companies) 

except in relation to 

goodwill; and a system that 

removes the uncertainty on 

the treatment of UPEs more 

generally by clarifying that 

all UPEs are loans for 

Division 7A purposes. 

5. A self-correcting 

mechanism  

From: A complex area of the 

tax law system that brings 

substantial compliance and 

administrative costs and 

where there is no ability for 

taxpayers to self-correct 

mistakes and omissions and 

which require the exercise 

of the Commissioner’s 

discretion in order to avoid 

a deemed dividend. 

To: A self-correction 

mechanism which would 

enable taxpayers to put in 

place complying loan 

agreements, reduce 

compliance and 

administrative costs and 

substantially reduce the 

number of cases that would 

require a decision by the 

Commissioner. 

Chapter 6 of the discussion 

paper outlines reforms 3, 4 and 

5 in further detail. 

With respect to 2. above, and 

asset revaluations that currently 

are required to be included in 

calculating 'distributable 

surplus', the BoT's preliminary 

view is that it would provide 

increased fairness to excluded 

unrealised gains from the 

calculation, except in cases 

where those gains are the 

subject of a permanent transfer 

of value (for example, by asset 

transfer). The testing of 

distributable surplus would be 

at each year end. Whilst under 

this approach a temporary 

transfer of value (such as a loan) 

may not be treated as a deemed 

dividend in the year that the 

loan is made i.e. because there 

may be no distributable surplus, 

the loan (if it still exists in a 

later year) may be treated as a 

deemed dividend in that later 

year if at the end of that year 

there is a distributable surplus. 

The second discussion paper 

includes further comments and 

recommendations by the BoT in 

respect of the three alternatives 

approaches to reform Division 

7A as outlined in the first 

discussion paper. Dealing firstly 

with the distribution model the 

BoT has concluded that this 

alternative should only be 

pursued as part of a broader 

review of the small business tax 

system that includes an 

examination of the progressivity 

of the income tax system as a 

whole. The BoT has suggested 

that the Government's proposed 

White Paper on the tax system 

may be an appropriate forum 

for undertaking this 

examination. 

In our view, the decision of the 

BoT not to pursue the 

distribution model is welcomed, 

as this was the least preferred of 

the original models in that it 

would have forced private 

companies to repatriate profits 

to shareholders if the profits 

were not used for working 

capital. Public companies are 

not subject to the restraints of 

Division 7A, and this model 

would have placed private 

companies at a competitive 

disadvantage.  

With respect to the statutory 

interest model under which 

loans to related entities would 

be required to carry a statutory 

rate of interest, (but with no 

requirement that principal be 

repaid prior to termination of 

the loan), the BoT's view, as 

expressed in the second 

discussion paper, is that to 

ensure that shareholders do not 

receive a benefit where the loan 

is for private purposes, the 

model would require the 

statutory interest rate that 

compensated for the interestonly nature of the loan.  

According to the BoT, this rate 

would be considerably higher 

than the current Division 7A 

rate. In our view, if this model 

was adopted, a proposed 

statutory rate should be no more onerous than the rate that 

could reasonably be expected to 

be obtained from a commercial 

lending institution for a similar 

amount and under similar terms 

and conditions.

In its second discussion paper 

the BoT states that if the 

statutory interest model was to 

be adopted, other aspects of 

Division 7A reform would still 

be needed to deal with benefits 

provided other than as loans 

such as the forgiveness of debts. 

The BoT also raises concern that 

whilst this model would be 

effective where the funds 

borrowed from the company are 

for private purposes (such that 

the interest paid in not tax 

deductible), there would be a 

significant cost to the revenue in 

other situations for the 

following reasons: 

 the difference between the 

corporate tax rate and the 

personal tax rate such that 

the interest expense could 

shelter income from tax that 

would otherwise attract tax 

at higher than the corporate 

rate (which would apply to 

the interest received by the 

private company lender)  

 the absence of the 

requirement for regular 

repayments of principal 

would remove a key 

incentive for the private 

company to declare 

dividends each year to fund 

principal repayments 

leaving the borrower in a 

better position to avoid the 

payment of 'top-up tax'  

 the model allows funds 

taxed at the corporate rate 

to be directed towards 

investments that on 

realisation would be eligible 

for the Capital Gains Tax 

(CGT) discount.  

In conclusion, the BoT states 

that having regard to the 

extended terms of reference, 

there is scope to consider 

whether the potential benefits of 

the statutory interest model 

outweigh the additional cost to 

revenue, and has requested 

input from stakeholders on this 

issue. 

With respect to the Division 7A 

adjustment model the BoT 

states that the advantage of this 

approach is that it could deal 

with known issues within the 

context of the provisions already 

familiar to practitioners and the 

Australian Taxation Office. The 

BoT notes however that based 

on responses received, this was 

not the preferred model. Whilst 

the BoT concludes that adopting 

this model would have limited 

impact in moving the system in 

the direction of the BoT's 

preferred policy framework, to 

the extent to which other 

models are silent on aspects of 

Division 7A, parts of the 

Division 7A adjustment model

may still be utilised. 

In our view, the Division 7A 

adjustment model, which is 

simply a 'patchwork' approach 

to dealing with the problems in 

applying Division 7A, is 

undesirable as it may lead to 

additional complexity and 

compliance costs for taxpayers. 

The complexity of legislative 

amendments made to the 

originally enacted provisions 

and the uncertainty created by 

some of those amendments 

suggest that a complete 

overhaul of the regime is the 

better approach. 

In Chapter 6 of the discussion 

paper, the BoT provides further 

detail on reforms 3, 4 and 5 

outlined above. In summary the 

reforms are: 

1.  A new, simplified regime to 

replace the existing 

provisions relating to 

'Division 7A complying 

loans' including: removing 

the requirement for a 

formal loan agreement; 

providing flexibility with 

respect to the payment of 

interest and principal but 

with statutory repayment 

percentages at the end of 

years 3, 5, 8 and 10; a 10 

year loan term for all loans; 

fixing interest rate and 

repayment milestones at 

commencement of the loan.  

2. A limited exclusion from the 

application of Division 7A to 

unpaid present entitlements 

(UPEs) owed by trusts that 

nominate to 'tick the box' 

and forgo access to the CGT 

discount on disposal of 

assets. Under this proposal 

all UPEs would be treated as 

loans for Division 7A unless 

the 'tick the box' option was 

chosen. 

3. A mechanism to allow 

taxpayers to self- correct 

mistakes or omissions 

without having to apply to 

the Commissioner for the 

exercise of his discretion. 

We support the introduction of 

a new, simplified regime to 

replace the existing provisions 

relating to Division 7A 

complying loans. Removing the 

requirement for formal loan 

agreements and setting a 

commercial rate of interest at 

the start of the loan period is 

welcomed, however it is 

disappointing that the proposal 

includes a requirement to make 

fixed repayments of interest and 

principal at the end of years 3, 5 

and 8. Ensuring that these 

repayments are met may require 

repatriation of profits (as 

dividends) depending on the 

circumstances including 

whether the company has a 

distributable surplus at the 

relevant milestone. A legislative fix to align the 

treatment of UPEs with other 

Division 7A loans is welcomed. 

Although not critical of the 

concessions which are currently 

in place for UPEs, the existing 

UPE rules are complex and 

cumbersome and do not help 

small businesses get on with 

what small businesses do - 

employing Australians. The 

suggested 'tick the box' 

approach for trusts which will 

operate to exempt UPEs from 

the operation of Division 7A is 

on the face of it is a reasonable 

approach to deal with the 

complexities that would 

otherwise arise. However, the 

full details of the proposal 

(including any transitional 

rules) will need to be considered 

before reaching a concluded 

view on the merits of the 

proposal.

The introduction of a selfcorrection mechanism for 

taxpayers would be welcomed. 

However, the practical 

application of this may be 

problematic in some 

circumstances. As with all the 

issues raised by the BoT in its 

discussion paper, the full details 

of the proposal will need to be 

considered before reaching a 

concluded view on the merits of 

the proposal.

The BoT's discussion paper 

indicates the need to overhaul 

Division 7A because of the 

complexity and inequity that 

currently exists. The discussion 

paper gives taxpayers the 

opportunity to have their say, 

and we would welcome the 

opportunity of working with 

taxpayers to achieve appropriate 

outcomes.  

PwC Australia - Kel Fitzalan, Paul Brassil, Bruce Ellis, Chris Lowe and Cesare Scalise

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