Division 7A has been described as an accountant’s worst nightmare. It basically tries to deal with all types of leakages from a company to its shareholders or associates of a shareholder in the case of a private company that is a beneficiary of a family trust. If a transaction (i.e. loan, payment) or benefit (debt forgiven, use of a company asset) are caught by these anti-avoidance rules, a deemed unfranked dividend may result in the hands of the shareholder. Effectively, Division 7A tries to create a taxing point for these types of leakages, which would otherwise slip through the tax net.
Shareholders, particularly a husband and wife team running a business through a company, cannot see what all the fuss is about. As far as they can see it’s their money tied up in the company, so what is wrong with them accessing such funds for private purposes? Without Division 7A, these types of distributions would not be assessable to shareholders. An entity such as a company is a separate entity from its owners, and businesspeople tend to be ignorant of this. Division 7A creates a taxing point when shareholders try to take advantage of assets owned by the company. This can be done by accessing money via loans, having the company pay for private expenses and/or forgiving past loans. Use of company assets such as property or vehicles is also caught by Division 7A when shareholders are not employees of the company, which would otherwise be caught by FBT.
Things get particularly complicated when a private company is a beneficiary of a family discretionary trust (which is an associate of a shareholder) and the company’s entitlement to a trust distribution remains unpaid (known as ‘unpaid present entitlements’ or UPEs). Division 7A can treat UPEs as if the company has made a loan back to the trustee, potentially triggering a deemed dividend from the company to the trustee.
UPEs are an important practical topic for tax professionals. Many small business entities operate their businesses through a trust and use a bucket company as a beneficiary of the trust to enable the business to access internal funding. A trust must distribute all taxable income. Having a bucket company limits the tax paid to 30 per cent and enables the trust to borrow back such income for working capital purposes. The Board of Taxation (BOT) in its November 2014 Post Implementation Review of Division 7A, acknowledged “UPEs provide a significant source of funding … used by business taxpayers for working capital purposes”.
To cut a very long story short, 2009 saw the ATO shift its thinking around whether UPEs were caught by Division 7A. The tortuous nature of the ensuing discussions lead to the release of the following outcomes: tax ruling TR 2010/3 and practice statement PS LA 2010/4.
TR 2010/3 Division 7A: trust entitlements
This ruling expresses the Commissioner’s view that a UPE is capable of amounting to the provision of financial accommodation by the private company beneficiary in favour of the trust, and may therefore be a loan for Division 7A purposes. The view expressed applies to all types of trusts, including discretionary trusts and unit trusts. The view expressed is particularly relevant in cases where the trust and the private company are part of the same family group. As the Commissioner first expressed his view on 16 December 2009, the ATO will only apply this view to UPEs that came into existence on or after this date.
PS LA 2010/4
This practice statement provides practical guidance on how to administer taxation ruling TR 2010/3. The practice statement provides practical ways for businesses to work towards a compliance structure with minimal impact on their cash flow, and can be summarised as follows:
Option 1 – interest-only 7-year loan
Option 2 – interest-only 10-year loan
Option 3 – invest in a specific income-producing asset or investment
Amount of the annual return
Main trust to pay interest calculated at the benchmark interest rate to the sub-trust.
Main trust to pay interest calculated at the prescribed interest rate to the sub-trust.
Sub-trust is entitled to receive the share of net return (e.g. interest income or rental income) derived as a result of the specific asset or investment to the sub-trust.
Sub-trust to pay annual return to the private company beneficiary by the lodgement day of the income tax return for the main trust, except for the final payment of the annual return, which must be paid to the private company when the investment or loan is due to be repaid.
Nature of the annual return
Interest.
Interest.
Depends on the specific asset or investment.
Repayment of the funds representing the UPE (the principal)
The principal must be repaid at the end of the 7-year loan.
The principal must be repaid at the end of the 10-year loan.
The principal must be repaid by the lodgement day of the tax return of the private company beneficiary for the year in which the investment ends.
Deductibility of the annual return
Yes, the amount is deductible to the main trust provided that the trustee of the main trust satisfies section 8-1 of the ITAA 1997.
Yes, the amount is deductible to the main trust provided that the trustee of the main trust satisfies section 8-1 of the ITAA 1997.
No.
Assessability of the annual return
Yes, the amount is assessable to the private company beneficiary.
Yes, the amount is assessable to the private company beneficiary.
Depends on the specific asset or investment.
Sub-trust tax return
Not required.
Not required.
Required.
Effectively PS LA 2010/4 started clocks ticking by providing time to identify practical ways for businesses to work towards a compliant Division 7A structure.
Part of the administrative solution previously adopted for UPEs arising from 16 December 2009 enabled a trustee to invest a private company’s UPE without the UPE being treated as an in-substance loan under Division 7A. This solution involved the ATO treating the funds representing the UPE as held under a sub-trust arrangement for the sole benefit of the private company beneficiary. To demonstrate that funds in the sub-trust were indeed so held, PS LA 2010/4 (paragraphs 40 to 100) required the funds to be invested in the main trust using one of three investment options. Essentially, the investment options available were two types of interest-only loans (a seven-year or 10-year loan) or an investment in a specific income-producing asset or investment.
Ticking time bomb
Repayment dates for the funds representing the UPE (i.e. the principal) under the ‘Option 1’ investment approach – the seven-year loan – are almost upon us, and there is tension building among practitioners concerned about the ability of clients to meet the repayment deadlines.
Help may be on the way according to the 2016-17 federal budget papers: while light on detail, it included the following announcement in relation to Division 7A:
- Simplification of Division 7A, and
- “Subject to the outcomes of consultation”, amendments that will include:
- A self-correction, no-penalty mechanism for taxpayers who have inadvertently triggered Division 7A;
- Amended rules, with appropriate transitional arrangements, regarding complying Division 7A loans, including having a single compliant loan duration of 10 years and better aligning calculation of the minimum interest rate with commercial transactions.
Note: The BOT Post 2014 Implementation Review of Division 7A recommended removing impediments to the reinvestment of business income as working capital. It proposed 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 trade-off, trading trusts that make this election will be denied the CGT discount (like companies) except in relation to goodwill. The BOT recognises that the current process imposes significant complexity where trusts retain funds distributed to companies as working capital.
The proposed federal budget changes are expected to commence from 1 July 2018, just about when the clock stops ticking and loan repayments become due. Let’s hope Treasury get their skates on well before the aforementioned repayment deadlines start, to hit to ease practitioner concerns.
