The Board of Taxation released its Second Discussion Paper on Division 7A of the Income Tax Assessment Act 1936, on 25 March 2014.
Division 7A taxes notional distributions (by way of loans, payments or forgiven debts) from private companies (which are taxed at the rate of 30%) to shareholders and associates (who are taxed at higher marginal tax rates) as unfranked “deemed dividends”. Division 7A also operates where private company assets are used by shareholders and associates, and where a trust has an unpaid present entitlement (UPE) owing to a private company (directly or indirectly through one or more interposed entities), and makes a payment or loan to, or forgives a debt owing by, a shareholder (or an associate of a shareholder) of the private company.
In the Discussion Paper, the Board recognises the need for businesses to reinvest funds as working capital and for a distinction to be drawn between reinvesting funds for business needs versus using funds for private purposes.
“The Board’s main observation is that, in its current form, Division 7A fails in achieving its policy objectives... Division 7A can be a significant source of compliance costs for businesses… The Board considers that protecting the progressivity of the tax system should not be at the expense of impeding the ability of businesses to reinvest their income as working capital. Facilitating this reinvestment supports improved productivity and entrepreneurial growth...”
The Discussion Paper proposes the following five reforms (while the Paper discusses transitional arrangements, there is no indication in the Paper as to when the reforms would operate from):
- A new unified set of rules based on the principle of “transfers of value”, having a single set of common principles dealing with loans, payments, debt forgiveness and the use of company assets.
- A targeted framework for calculating a company’s profits by:
a. not requiring asset revaluations;
b. not requiring unrealised profits to be distributed where company assets have been used; and
c. testing company profits each year to appropriately tax all transactions;
Under the current rules, the amount of Division 7A deemed dividends is limited to a company’s “distributable surplus”. As calculation of the distributable surplus is based on the values of assets, formal valuations can be costly to small businesses and informal valuations do not provide certainty.
- A single 10-year loan period with flexible requirements for principal repayments, and no requirement for a formal written agreement (only written or electronic evidence that a loan was entered into by lodgement day for the income year in which the loan was made).
This contrasts with the present requirement for “complying loans” with a maximum term of 7 years (for unsecured loans) or 25 years (for loans secured against real estate) and inflexible terms for repayments of interest and principal; and the 7 and 10 year interest-only loans for UPEs held on sub-trust arrangements.
- Greater flexibility for trusts that reinvest UPEs as working capital by:
a. treating all UPEs as loans for Div 7A purposes; and
b. providing trading trusts with the option to retain post-tax profits (but such trusts would be denied the CGT discount except in relation to goodwill).
This would eliminate the requirement to place a UPE on a “sub-trust” arrangement and comply with evidentiary requirements in the Commissioner of Taxation’s Practice Statement PS LA 2010/4.
- Enabling taxpayers to initiate complying loan arrangements (as a self-correction mechanism), instead of having to rely on the Commissioner’s discretion to avoid a deemed dividend.
This contrasts with the present “strict liability” approach where taxpayers have no ability to self-correct mistakes or omissions and must request the Commissioner to exercise a discretion in order to avoid a deemed dividend, which results in unnecessary compliance costs.
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