Tax: Michael Parker and Andrew OBryan consider the implications of the less-publicised changes to Division 7A.
Since its introduction in 1997, Division 7A has been effective in preventing shareholders from taking money out of a private company without paying tax.
However, in achieving this outcome the provisions operate to catch a wider group of taxpayers who may inadvertently trigger a deemed dividend. A severe penalty is imposed for such a breach.
Loans, advances and other payments to shareholders or their associates would be treated as assessable dividends to the extent that there are realised or unrealised profits in a private company, unless these amounts fell within the limited defined exclusions.
In addition, where a deemed dividend arose under Division 7A, a private company's franking account would be debited without enabling shareholders or their associate to access the benefits of these wasted franking credits.
Recent amendments to Division 7A have limited the scope of its application and reduced the severity of the penalties for a breach, with parliament acknowledging that the penalties contained in Division 7A far outweigh the potential tax mischief.
Reducing Division 7A's punitive nature
In June this year significant amendments were made to the operation of Division 7A. In particular, these amendments are aimed at reducing the punitive nature of Division 7A, as well as the extent to which taxpayers can inadvertently trigger a deemed dividend under the provisions.
Much has been said and written on the amendment to Division 7A, which provides the tax commissioner with a general discretion to disregard a deemed dividend. This will occur when there is evidence that a taxpayer has attempted to comply with Division 7A but has made an 'honest mistake or inadvertent omission' and efforts have been made to rectify the mistake.
In addition to this favourable amendment, there are a number of other less-publicised measures, which will come as welcome relief to shareholders in private companies.
Removal of automatic debit to franking account
Division 7A previously operated to impose a double penalty. Where a deemed dividend arose under Division 7A the shareholder would be assessed on an unfranked dividend, while the private company's franking account would be automatically debited despite the fact that the deemed dividend was not a frankable distribution.
Where the company had insufficient franking credits, a franking deficit tax liability would arise and two separate rounds of tax could potentially be payable.
The amendments to Division 7A eliminate this 'double penalty' by providing for the removal of the automatic debit to the private company's franking account, while the deemed dividend is still taxable in the shareholder or associate's hands without access to franking credits, unless the commissioner exercises a discretion to allow the company to frank the dividend.
While this amendment is welcomed as good news, there is cold comfort for shareholders who, as a result of the operation of Division 7A, may create a franking credit trap, if the private company has excess franking credits but insufficient retained earnings to declare a fully franked dividend.
Failure to make minimum yearly repayment
A Division 7A compliant loan requires the borrower to make minimum yearly repayments over a maximum term of 25 years for loans secured by a mortgage over real property, or seven years in all other circumstances.
Previously, Division 7A would operate where the amount paid on an amalgamated loan by a borrower falls short of the minimum yearly repayment for the income year, a deemed dividend would arise in the amount of the balance of the amalgamated loan that had not been repaid at the end of the income year.
For example, say Trump Pty Ltd makes a $500,000 loan to Ivana who is a shareholder of that company. The minimum yearly repayment for the loan is $95,000, including principal of $57,000 and interest of $38,000. During the first year after the loan was made Ivana only makes a repayment in the amount of $50,000. By applying the old provisions of Division 7A, a deemed dividend of $488,000 will arise being the outstanding balance of the loan.
The amendments significantly change this outcome and reduce the potential penalties contained in Division 7A.
As from 1 July 2006, when a borrower fails to make the minimum yearly repayment, the amount of the deemed dividend will reflect the shortfall of the repayment and not the outstanding balance of the loan. So now, in the example above Ivana would be assessed to a deemed dividend in the amount of $45,000 (being the minimum yearly payment of $95,000 less the actual repayment of $50,000).
Calculating the distributable surplus
A deemed dividend under Division 7A can only arise to the extent that the private company has a 'distributable surplus' in the year in which the deemed dividend arises.
Previously, the commissioner was given the power to review the private company's accounting records to determine whether the book value of any assets were significantly undervalued or provisions were significantly overvalued. The commissioner would then be able to revalue those items to reflect a market value that was considered to be more appropriate. As such, the distributable surplus would reflect both the realised and unrealised gains of a private company to the advantage of the Tax Office.
Following the amendments, the commissioner's power has been extended to enable revaluation of an asset downwards if the book value is significantly greater than the market value.
The commissioner can revalue provisions upwards if the situation is reversed in effect, reducing the amount of the distributable surplus. This amendment comes as good news to shareholders in private companies, and provides for a more equitable treatment of private companies and their shareholders.
Changing the term of a loan
The amendments (that a Division 7A- compliant loan can be repaid over a maximum term of 25 years for loans secured by a mortgage over real property or seven years for unsecured loans) now enables shareholders to convert an unsecured loan to a secured loan, extending the term in which the loan is to be repaid.
The maximum term of the secured loan is 25 years less the period of the term already expired in the unsecured loan. This will provide shareholders who are unable to meet the minimum yearly repayments calculated on a seven-year loan due to cash flow problems with the ability to extend the term of the loan and reduce the amount of the required payments. This is likely to be useful when shareholders have properties that have risen in value, giving them available net equity in the property.
Conversely, the amendments also enable a shareholder to convert a secured loan to an unsecured loan, thereby reducing the term of the loan and the amount of interest payable on it.
Marriage breakdown
A Division 7A liability may arise on payments or transfers of property as a result of a marriage breakdown. These payments or property transfers may be involuntary, occurring pursuant to a court order.
Although other areas of tax law have recognised the need to address the taxation implications arising from a marriage breakdown (such as capital gains tax rollovers), Division 7A has operated in such a manner as to capture and penalise shareholders and associates of private companies.
The amendments now provide that a deemed dividend arising as a result of a payment from a private company to a shareholder or an associate of the shareholder (for example, an ex-spouse) forming part of a 'family law obligation' may be frankable. The concept of a family law obligation is defined to cover the same situations in which the CGT rollover will apply.FBT-exempt loans
Tax practitioners have experienced confusion about the interplay between Division 7A and fringe benefits tax when a loan is made to an individual who is both a shareholder and employee of a private company.
The amendments now remove any uncertainty by amending the Fringe Benefits Tax Assessment Act 1986 to provide that FBT will not apply when the loan satisfies the criteria of an excluded loan set out in section 109N.
Section 108 repealed
Section 108 was the predecessor to Division 7A and has finally been laid to rest. The government has acknowledged it overlaps with Division 7A and is 'no longer considered necessary'.
Although it was rarely used due to its many shortcomings, practitioners have long feared its residual application. This was particularly so in relation to loans to other companies and any loans made before 4 December 1997.
Section 108 can now only apply to assessments for income years preceding 1 July 2006. Does this mean pre Division 7A loans that were not caught by section 108 are now safe?
Before you get too excited about the demise of section 108, bear in mind one factor: the 'general' dividend provisions can still apply. A dividend is defined in section 6(1) of the 1936 Act to include 'any amount credited by a company to any of its shareholders'.
If you have an old loan sitting in the books, how do you get rid of it? The journal entry has to be something like: Dr Retained profits Cr Shareholder loan
Such action can, in our view, simply give rise to an ordinary section 44(1) assessable dividend. If the loan is to an associate rather than a shareholder, section 44 will not apply. However, there may be circumstances where writing off the loan to an associate gives rise to other tax consequences (such as a fringe benefit).
In short
Since its introduction, Division 7A has operated in a fashion that has created headaches for shareholders of private companies and the tax practitioners who advise them. Its application has seemingly far exceeded its underlying policy intent.
The recent amendments have been welcomed as they now curb the situations in which Division 7A will apply, and substantially lessen the penalties imposed when the provisions are inadvertently breached.
Although much hype surrounded the introduction of the commissioner's discretion to disregard a deemed dividend in certain circumstances, there is further joy for shareholders of private companies in the less-publicised amendments. All tax practitioners should be aware of these amendments and their potential application.
