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.
