Div. 7A ITAA 1936 private company deemed dividends is a commonly encountered problem area for practitioners, which is difficult to construe and apply, often misunderstood by clients and practitioners and results in high compliance costs and frequent and unintended breaches.
On 25 March 2014, the Board of Taxation (BOT) issued the 2nd BOT Discussion Paper and proposed a new ‘transfer of value model’ for reforming Div. 7A. The model has much to commend it.
Broadly, the proposal is:
- legislative drafting based on the distinction between ‘temporary transfers’ (loans and use of assets) and ‘permanent transfers’ (payments, debt forgiveness and asset transfers) and between ‘passive assets’ and ‘active assets’;
- annual testing and progressive deemed dividends over the life of temporary transfers based on a revised ‘distributable surplus’ methodology that exclude unrealised gains that are not related to permanent transfers;
- a single 10 year loan at the Reserve Bank of Australia small business indicator interest rate (e.g. 10%) with prescribed maximum loan balances at year 3 (75%), at year 5 (55%), at year 8 (25%) and the balance at year 10 and interest at least payable at these dates (‘Rule of 78 Loan’);
- UPEs to and loans from a private company beneficiary constituting a temporary transfer, unless the trust ‘ticks-the-box’ to forego the CGT discount (other than on goodwill); and
- self-assessed corrective action mechanisms.
Rule of 78 Loans
The standardisation of the 7 year (unsecured) and 25 year (secured) principal and interest complying loans and the 7 year (unsecured) and 10 year (unsecured) interest only UPE investment agreements to a single 10 year ‘Rule of 78 loan’ will no doubt have winners and losers.
Broadly, The Rule of 78 apportions the total interest payable under a loan in accordance with an arithmetic progression. Under the rule the early instalments include larger interest components than the later ones, generally for loans of less than 18 months (Ruling TR 93/16).
Particularly, one would like to forecast the extent of any consequential impact on the taxpayer and the property market of shortening the 25 year loan used to acquire long term real property.
Tick-the-Box Trust Elections
As a compromise, the ‘tick the box’ option has significant appeal, providing a practical and simple solution to the UPE problem, whilst balancing the policy considerations. However, the compromise is not necessarily consistent with policy.
The tick-the-box approach does not adequately recognise that the CGT discount can be indirectly obtained by a sale of shares in the Trading Company P/L. Since the opportunity to sell shares in, rather than the business of, Trading Company P/L is market driven and not policy driven, the entrenching of a restrictive policy position over a more favourable policy position is harsh.
Small businesses are likely to elect to tick-the-box where the CGT small business concessions would shelter the capital gain despite the loss of the CGT discount. The loss of the CGT discount for taxpayers that do not qualify for the CGT small business concessions may require restructuring to preserve the CGT discount.
Self-corrective action is an imperative reform.
It is unclear why there should be a culpability threshold (objectively not deliberately ignored or attempted to circumvent Div. 7A) for corrective action. Effective corrective action removes the previous tax benefits. Effective corrective action would be encouraged if corrective action has been commenced or completed before notification of an audit or review and after commencement of an audit or review was not susceptible to a penalty reduction for voluntary disclosure or permitted without the approval of the Commissioner.
Detailed consultation on the 2nd BOT Discussion Paper proposal will no-doubt fill in needed detail and refine the proposal, but implementation would seem a long way off in the future.
In the interim, clients and practitioners must manage the current Div. 7A difficulties and attempt to ensure that any structuring will not have adverse consequences arising from the reform of Div. 7A.