Proposed changes to Division 7A – Better may become worse
Australian Tax Law – Debit Loans to Company Shareholders
We have previously addressed the issue of Division 7A, debit loans to company shareholders, and the potential devastating financial consequences if not dealt with properly. To refresh your memory, Division 7A is of the tax legislation is an integrity measure by the ATO to prevent shareholders (or family members) taking profits out of companies in a manner other than as income in the shareholder’s hands. Before Division 7A, it was not uncommon for company owners to take monies out of the company in the form of “loans” which were not taxed in the shareholder’s hands causing tax leakage for the tax office. Division 7A was introduced a deterrent by deeming such loans to be a dividend in the shareholder’s hands and subject to income tax without the benefit of any franking credits.
Where a loan is taken from a company, the ATO has one of three expectations of the shareholder:
- Repay the loan in full before the company’s tax return is lodged,
- Place that loan on the same footing as if it were a loan provided by a bank. That is, have a loan agreement with interest and loan repayments, or
- Be taxed on the loan.
The upshot of Division 7A, particularly for small business, is that it is convoluted, complex and increases annual compliance costs to companies. In 2012, the Board of Taxation recognised this problem and set the objective of reducing the compliance burden and increasing cash flow by setting out to propose some changes.
In 2014, the Board of Taxation released a paper containing proposals with most of them representing welcome relief. Then the Treasury got involved. In October 2018 they released a paper with their own ideas of the needed changes. Unfortunately, Treasury lost the spirit of the Board of Taxation’s original proposal.
The following table outlines the differences where they loan agreement approach to dealing with Division 7A.
|Current Division 7A provisions||Board of Taxation original proposal||Treasury’s amended proposal|
|7 year loan term, 25 years where the loan is secured by mortgage||7 year loans will be replaced with 10 year loans – first three years interest only||10 year complying loan term replacing both 7 and 25-year loan terms. Repayments will be required annually containing equal amounts principal over the life of the loan|
|Written agreement required||Formal written loan agreement not required||Formal written loan agreement not required|
|Interest calculated on the existing loan balance||Interest calculated on the existing loan balance||Interest calculated on the opening loan balance|
|Current interest rate is 5.2% for the year ending 30 June 2019||Benchmark interest rate increased by more than 3% to the present 8.3% overdraft rate, with a three year interest only period||Benchmark interest rate increased by more than 3% to the present 8.3% overdraft rate|
|Deemed dividend limited to company profits cap||Deemed dividend limited to company profits cap||Company profit cap has been removed|
|Pre-1997 loans are exempt from Division 7A||Pre-1997 loans are exempt from Division 7A||Pre-1997 loans having to be repaid over 10 years with interest|
|Trust Unpaid Present Entitlements (UPE) can be placed on a sub-trust or put on loan terms||Trust UPE are required to be put on loan terms||Trust UPE are required to be put on loan terms by lodgement of 2019 tax return – First repayment due in 2019-20 income year|
|7 year loan period||7-Year loans transitioned over to 10 year loans||7-year loans to be transitioned into new regime using the remaining life of the loan from 1 July 2019|
|25 loan period where secured by mortgage||25 year loans can be transitioned into the new regime over 25 years||25 year loans are to be placed on 10 year complying loan agreements from 1 July 2021|
|2 or 4 year review period depending on the circumstances||4 year period of review||Period of review extended to 14 years.|
What does this all mean?
At this stage, it is unclear which proposals will be adopted. The Board of Taxation’s original intention was to reduce compliance obligations and increase cash flow. Treasury’s proposals achieve neither.
Treasury’s proposals will lead to greater difficulty in meeting minimum annual repayments, companies with pre-1997 loans will be dragged into the regime and the removal of distributable profit cap seems far from fair and is contrary to the driving reasons for implementing Division 7A in the first place.
Division 7A rules are complex and therefore can easily be unintentionally breached resulting harsh pecuniary penalties. For those companies with Division 7A loans, this is no time to stick your head in the sand because clearly, it’s important to understand the potential impact of the changes on company and shareholders and plan to mitigate them.
Written by Chieftains an accounting firm that exists to help business owners increase profits and reduce risks allowing them to astutely provide for their retirement.
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