The Division 7A provisions within the Tax Act play a critical role in governing how individuals borrow money from their businesses or tax effectively finance investment activities. In a move that may surprise many who already struggle to follow this technical area, the Australian Government appears set to change these rules from as soon as 1 July 2019. The proposed changes could create cash flow issues for many as a result of shorter or altered loan terms, higher interest payments and more immediate principal repayments. For this reason, we are encouraging clients to urgently review the proposed changes and consider their Division 7A–related strategies.
What is Division 7A?
Division 7A is a tax integrity rule that applies to shareholders of private companies, which may include individuals or trusts. If the company makes a payment or provides a loan to a shareholder, the government will treat the funds as unfranked dividends that add to the recipient’s taxable income – unless they use the Division 7A provisions to convert the amount into a complying loan.
These loans currently run for seven years unsecured or 25 years, if the shareholder agrees to provide property as security. During that time, the shareholders must repay the principal and pay interest, at the ATO Commissioner’s benchmark interest rate (currently 5.30%). Division 7A also extends to debt forgiveness and the private use of company owned assets, such as a boat or holiday house.
What is changing?
The government flagged its intention to revise Division 7A in the 2016/17 Federal Budget and has since provided some safe harbour conditions in anticipation of making amendments. It has now released a new consultation paper that provides further detail on the potential shape of the new regime and indicates it might be in place as soon as 1 July 2019. While the new rules are yet to be finalised and must still be legislated, our view is that the paper indicates the likely shape of the new rules. Given there is broadly bipartisan support for the changes, we also believe they may be passed.
Here is a summary of the proposed changes, each of which is discussed in detail below.
- Loan terms will change from a maximum of seven or twenty-five years to a flat ten years.
- The interest rate on 7A loans will increase from 5.30% to 8.30% (rates are as of today).
- Interest repayments will be calculated on the amount owing at the start of a financial year, even if funds are repaid during the year.
- There will be no limit on deemed dividends, due to the abolition of the distributable surplus.
- Unpaid present entitlements will be caught in tax law and must become 10-year principal and interest Division 7A loans.
- Calculation of repayments and interest will be simplified and the need for written loan agreements will be removed. It will also become easier for taxpayers to correct any inadvertent errors.
The following scenarios show the potential implications of the changes for an individual who has borrowed from his or her private company, and a private group that currently uses a corporate beneficiary.
Raymond, a shareholder of XYZ Pty Ltd withdraws $50,000 from the private company to partly fund his family holiday. As at 30 June 2019, Raymond has not reimbursed XYZ Pty Ltd for his getaway and the $50,000 remains outstanding as at the lodgement due date for XYZ Pty Ltd. Under the existing Division 7A rules, Raymond can place the $50,000 on a 7 year complying loan agreement at an interest rate of 5.2% (current rate for the 2019 year). The minimum yearly repayment required to be made prior to 30 June 2020 would be $8,704 (interest component being $2,600). Contrast this to the proposed changes, the loan term will change to a maximum of 10 years and the interest rate will be 8.3%. Under the proposed changes, the minumum yearly repayment would be $9,150 (interest component being $4,150). An increase in the interest component and miniumum yearly repayment required which will cause Raymond some cash flow issues.
A variation to the above example would be if Raymond’s Trust, the Barona Family Trust makes XYZ Pty Ltd entitled to $100,000 of its share of profits for the year ended 30 June 2019 and does not actuall pay this amount to the company. The existing treatment of this unpaid present entitlement (UPE) would be for the Trust to place the UPE on sub-trust for 7 or 10 years on interest only terms (unless repaid prior to the lodgement due date). For the year ended 30 June 2020, interest income of $670 would be raised in the accounts of XYZ Pty Ltd with no principal amounts requiring repayment until the end of the loan term. Under the proposed changes, the interest only sub-trust option will no longer be available and the UPE must be placed on loan terms under the new 10-year loan model (unless repaid prior to the lodgement due date of the private compay). The minimum yearly repayment required for the year ended 30 June 2020 in respect of this UPE would then be $18,300 (interest component being $8,300). As you can see, the changes are likely to lead increased strain on cashflow and a requirement for this group to find an unexpected $17,630 in loan repayments by June 2020.
Proposed changes in detail
Simplification of loan terms
The current Division 7A rules require a minimum yearly repayment over the term of the loan (currently seven years for unsecured loans and 25 years for a secured loan). The discussion paper proposes that from 1 July 2019, all new loans must have a maximum term of 10 years, whether the loan is secured or not. Consistent with the existing rules, the loan term would begin at the end of the income year in which the advance is made.
The annual benchmark interest rate which is currently set by the ATO Commissioner (currently 5.30%) is to be based on the small business, variable indicator lending rate as published by the Reserve Bank of Australia before the start of each income year (8.30% as of September 2018).
The minimum yearly repayment will be simplified to consist of a principal and interest component that is easy to calculate. The principal component will be equal annual payments of the initial principal advance divided by the term of the loan.
The interest component will be the interest calculated on the opening balance of the loan each year using the benchmark interest rate as previously mentioned. Interest will be calculated for the full income year, regardless of when the repayment is made during the year (except in Year 1).
If the loan is repaid earlier, interest will not be charged for the remaining years.
Existing seven-year loans
All complying seven-year loans in existence on 30 June 2018 will have to comply with the new proposed loan model and new benchmark interest rate to remain compliant, but will retain their existing terms. That is, they cannot be extended to 10 years. Current loan agreements with written reference to the benchmark interest rate should not have to be renegotiated under this option.
Existing 25-year loans
All complying 25-year loan agreements in existence on 30 June 2019 will remain as is until 30 June 2021, at which point they can restart as a new 10-year loan. However, the interest rate payable for these loans during this period will have to equal or exceed the new benchmark interest rate.
Loans made before 4 December 1997 predate the introduction of Division 7A. However, under the proposed transaction rules any outstanding pre-1997 loans will need to transition to a 10-year term from 30 June 2021 if they are not already statute barred. This provides a two-year grace period before the first repayment is due, with the loan to be repaid over the subsequent 10 years. The taxpayer will have until the lodgement day of the 2020/21 company tax return to either pay out the amount of the loan or put in place a complying loan agreement, otherwise it will be treated as a dividend in the 2020/21 income year. The first repayment will be due in the 2021/22 income year.
Abolition of distributable surplus limit
The amount of the deemed dividend under Division 7A is currently limited to the distributable surplus of the private company that provides the benefit. The distributable surplus is essentially the net assets of the private company, which represents past and current profits.
The amendments will remove the concept of distributable surplus, resulting in no limit on a deemed dividend amount. This is contrary to the original intent and operation of the Division 7A integrity rule. A deemed dividend should emulate the situation of a real dividend where it is a distribution made out of profits.
Unpaid present entitlements to be included in tax law
An unpaid present entitlement (UPE) arises when a trust makes a private company a corporate beneficiary, thereby entitling it to a share of its profit, but does not pay the profit amount to the company in a given year. This is a common approach in private groups and the government’s proposed changes could have a significant impact on many from a cash flow point of view.
Currently, UPEs generally do not have a prescribed tax treatment under tax law. However, the Commissioner has taken the view that UPEs are generally within the scope of Division 7A under the extended meaning of a loan per the tax legislation unless the funds representing the UPE are held for the sole benefit of the private company.
This view is outlined in Taxation Ruling 2010/3 which applies to UPEs that arise after 16 December 2009. The Commissioner states that the funds can be held for the sole benefit of the private company if they are placed on sub-trust arrangements for seven or 10 years on interest-only terms with repayment of the principal at the conclusion of the loan.
The proposed changes state that all UPEs that arise on or after 1 July 2019 will need to be either paid to the private company or put on complying loan terms under the new 10-year loan model prior to the private company’s lodgement day, otherwise there will be a deemed dividend. That is, both principal and interest payments are required to be made each year, with the first due 30 June 2020.
The government is considering whether any transitional rules for sub-trusts that arose after 16 December 2009 should be introduced and whether pre-16 December 2009 UPEs should be brought within Division 7A. At this stage, it is unclear what the government will decide.
Given the complexity of Division 7A, it’s common for taxpayers to rectify inadvertent breaches – typically after their accountants have prepared their annual tax return. Traditionally this has been a laborious and expensive process involving a formal application to the Commissioner of Taxation.
The government is now proposing a self-correction mechanism that allows taxpayers to voluntarily rectify inadvertent breaches of Division 7A without penalty and without lodging an application for the Commissioner’s consideration. This should reduce effort and compliance costs.
Extension to review period
The review period in which the Commisioner can amend a tax return has been extended to 14 years after the end of the income year in which a loan, payment or debt forgiveness gave rise – or would have given rise – to a deemed dividend.
New safe harbour rules
The consultation paper proposes new safe harbour rules that provide certainty and simplicity for taxpayers. This includes formulas to calculate the arms-length value of a company’s asset that is being used by a shareholder or their associate.
Summary: positives and negatives
Your next steps
The government’s proposed changes are significant and, if passed in their current form, will have major implications for many companies, individuals and private groups as soon as mid-2019.
We urge clients and others to review their Division 7A–related strategies to ensure they will not be disadvantaged by the changes, and to make the most of any emerging opportunities. Even if the final regime is slightly different, it is clear that the government is paying close attention to Division 7A.
It is especially important to consider cash flow – particularly for those with UPEs owing to a corporate beneficiary and for which principal and interest repayments may become due from 30 June 2020.
Some of the responses we are already working on with clients include quantifying the potential impact of the changes, considering selling or refinancing assets, and creating new structures.
For more information or to discuss your situation, please contact our private clients team:
- Michelle Saunders: firstname.lastname@example.org
- Maddy Watt: email@example.com
- Nick James: firstname.lastname@example.org