At the NSW 11th Annual Tax Forum in May, Greg Travers, CTA, presented the session 'Practical Issues with Division 7A', where he provided an update on important Division 7A issues.
Greg looked at the ongoing use of corporate beneficiaries, managing the conclusion of sub-trust arrangements, how to approach resolving historical Division 7A issues, and the announced rewrite of key elements of Division 7A.
He also covered areas of focus for ATO audit activity, including interposed entity rules and the interaction with FBT, as well as recent cases, ATO rulings and guidance.
The paper he presented at the Forum is excerpted in this post.
Practical Issues with Division 7A: Introduction
Division 7A was introduced with effect from 4 December 1997 to replace s. 108. Division 7A was self-executing, overcoming one of the major deficiencies of s. 108.
In its original incarnation, Division 7A applied to payments, loans and debt forgiveness transactions between a private company and its shareholders, or associates of its shareholders.
The interaction of Division 7A with unpaid present entitlements to a trust distribution quickly became an issue.
With effect from 27 March 1998, Division 7A was amended to include s. 109UB. This section created the notion of a UPE as a Division 7A “trigger” - if a UPE with a private company was present, and the trust subsequently undertook a payment, loan or debt forgiveness transaction with a shareholder or associate of a shareholder of the private company, Division 7A was triggered.
Section 109UB had its own deficiencies that enabled it to be circumvented in many situations. The timing of creation of the UPE relative to the payment, loan or debt forgiveness transaction was one issue. The inability to deal with a chain of trusts was a further issue.
Section 109UB was repealed and replaced with Subdivision EA with effect from 12 December 2002. It was supplemented with Subdivision EB (dealing with interposed entity situations and UPEs) with effect from 1 July 2009.
At the same time as the Government was implementing the Subdivision EB amendments, the ATO released its views on the interaction of Division 7A and UPEs. These views are contained in TR 2010/3 and PSLA 2010/4. In the opinion of the ATO, UPEs will generally constitute loans within the extended meaning contained in s. 109D and so be within the scope of the general Division 7A provisions. Subdivision EA will continue to apply, but with a significantly curtailed role.
This view applies from 9 December 2009. Why it took the ATO over 20 years to determine its position, and why (based on the ATO’s interpretation) the Government continued to legislate specific provisions to deal with situations covered by the general provisions, both over time and also in 2009, are some of tax’s little mysteries. But until a taxpayer is prepared to challenge the view of the ATO, this is the interpretation that we must work with. It is set to become redundant soon anyway.
And despite predictions to the contrary, the world has not ended for private companies, nor for UPEs.
The need, or penchant, for amending Division 7A didn’t stop with the ATO position on UPE. In the 2016 Federal Budget further changes to Division 7A were announced.
One of these changes – the self-correction mechanism – is a welcomed change. Section 109RB may have been introduced with the best of intentions, but the drafting of the provision has meant that its actual application is much more restrictive than taxpayers (and I expect, the ATO) would have liked.
unpaid present entitlements come within the scope of Division 7A of the Income
Tax Assessment Act 1936 from 1 July 2019. This will apply where a related
private company is made entitled to a share of trust income as a beneficiary
but has not been paid that amount, known as an unpaid present entitlement.
that requires benefits provided by private companies to related taxpayers to be
taxed as dividends unless they are structured as Division 7A complying loans or
another exception applies. This measure will ensure the unpaid present
entitlement is either required to be repaid to the private company over time as
a complying loan or subject to tax as a dividend.
start date of the Ten Year Enterprise Tax Plan — targeted amendments to
Division 7A measure that was announced in the 2016-17 Budget from 1 July 2018
to 1 July 2019. This will enable all Division 7A amendments to be progressed as
part of a consolidated package.
The changes will be developed over the course of the next year, but in the meantime, we will continue to have to work with a set of rules that the Board of Taxation (refer Board of Taxation post implementation review of Division 7A, Report to Government, 12 November 2014) describes in less than glowing terms:
Division 7A are complex, inflexible and costly to comply with. They fail to
achieve an appropriate balance between ensuring taxpayers are treated fairly,
promoting voluntary compliance and discouraging non-compliance. They can also
operate as an unreasonable impediment for businesses operating through a trust
that wish to fund their growth by reinvesting profits back into the business.
However, what is also clear is that substantial amendment to the existing Division 7A provisions will occur in the coming years.
preventing shareholders from inappropriately accessing the profits of private
Australia operates a progressive taxation system. Division 7A supports progressive taxation by ensuring that private company profits that are enjoyed privately by shareholders are taxed at their personal marginal rates of tax.
Clearly the application of Division 7A has extended beyond just the private use of company profits by shareholders. For example, it applies to the retention of profits for working capital purposes by a trading trust. There is increasing acceptance that this outcome is not desirable, although there is far from consensus on how (or even if) to resolve this.
The Board of Taxation developed “guiding principles” to provide a coherent, workable framework to guide future reform of Division 7A. Three of the principles received broad support from those that made submissions. These three principles are:
- It should ensure that the private use of company profits attracts tax at the user’s progressive personal income tax rate.
- It should remove impediments to the reinvestment of business income as working capital.
- It should maximise simplicity by reducing the compliance burden on business and the administrative burden on the Commissioner and other stakeholders.
Few would argue with the merits of these principles.
The fourth principle is more contentious:
- It should not advantage the accumulation of passive investments funded by profits taxed at the company tax rate over the reinvestment of business profits in active business activities.
Whether this principle is adopted is a policy decision for the Government. If adopted, this principle would have a wide ranging impact in the financing of private groups.
In broad terms, there are three categories into which the use of private company profits by shareholders can be grouped:
- To finance business activities (reinvestment of profits of a business)
- To finance investment activities (acquisition of passive assets)
- To fund private expenditure
The first category has been problematic under Division 7A for businesses conducted by entities other than companies. The third category is the primary focus of Division 7A. The Board of Taxation recommended principles address both of these categories.
The middle category – financing investment activities – aligns with the fourth principle articulated by the Board of Taxation and is the category where there is the most conjecture.
Tax rate arbitrage
The arbitrage between tax rates is one of the main reasons why provisions such as Division 7A are needed.
The general corporate income tax rate is 30%, with the Government stating an intention to reduce this to 25% over the next 10 years. At the same time, Australia’s top marginal income tax rate for individuals is being maintained at or around 49%. The incentive to access a 30% tax rate, as opposed to a 49% tax rate, is clear.
If the two rates were aligned, the need for Division 7A is greatly diminished. Even though the vast majority of individual taxpayers have an effective tax rate of 30% or less, there is still a significant number of taxpayers with higher effective tax rates, and given the value of income involved, a real incentive to seek a lower tax impost.
A “UPE strategy” is a situation where a trust, usually a discretionary trust, resolves to make a company presently entitled to some or all of the net income of the trust. To the extent that the company is required to pay income tax on this distribution, the trust would usually (but not necessarily) pay that amount to the company. The balance of the distribution is retained by the trust and invested or utilised by it.
There are several factors which motivate use of a UPE strategy, with those factors varying depending on the legal structure of the particular private group.
Accessing the corporate income tax rate on funds retained within the private group (as opposed to funds released to the individual shareholders) is key. This is particularly the case where the income producing activities are undertaken by a trust.
Obtaining, or retaining, a solid level of asset protection is also important. The two most “at risk” taxpayers in a private group are the trading entity (exposed to business risks) and the primary individuals (usually also exposed to business risks, for example, through directorships). The family also has to manage family level risks such as marital breakdown.
A discretionary trust with a corporate trustee is an effective structure for achieving the asset protection objectives of a family group. The discretionary trust is commonly used to hold investment assets. As the individual family members do not have an ownership interest as such in the trust or its assets, the assets are in a large part protected from the risks attaching to the individuals.
Particularly for smaller businesses, a discretionary trust is also a common entity for conducting the business trading operations. The UPE strategy is used to enable reinvestment of profits in the business, or the accumulation of profits to finance the acquisition of investment assets.
For larger businesses where a company is the more common entity for conducting the business trading operations, the shareholder tends to be a discretionary trust. This later structure brings with it a further asset protection issue. Rarely will it be good practice to retain surplus assets (be it cash, investment assets, or something else) in the same entity that conducts an active trading business. For this reason, a private company will often dividend out its profits, with the discretionary trust shareholder employing a UPE strategy to manage the tax cost on the dividends through deferring the “top up tax” until the funds are actually paid to the individual family members.
The tax benefits of a discretionary trust are also a factor. In the context of Division 7A and UPE strategies, there are three main benefits:
- The trust is fiscally transparent, so use of this structure does not add further tax liabilities.
- The discretionary trust has flexibility in who income is distributed to. This flexibility assists with managing tax liabilities across a family group.
- A trust can access the CGT general discount.
The tax arbitrage on income is a timing difference, with top up tax being paid when the profits are ultimately distributed out of the “structure” to the individual owners. The tax arbitrage on capital gains is permanent. The trust making investments and distributing to individual taxpayers can utilise the CGT general discount, whereas the same investments made by a company will not benefit from the CGT general discount. Maximising access to the CGT general discount is a key factor in implementing a UPE strategy.
The Board of Taxation has recommended two models be considered as replacements for the existing approaches in Division 7A:
- The interest only model
- The amortisation model.
The interest only model is based on the three generally accepted guiding principles. The amortisation model, coupled with the business income election, also allows for the fourth guiding principle to be implemented.
Greg’s paper looks in more detail at both models, as well as the Business Income Election, which, coupled with the amortisation model, is being recommended by the Board of Taxation primarily to implement the fourth guiding principle, being that Division 7A should not advantage the accumulation of passive investments funded by profits taxed at the company tax rate over the reinvestment of business profits in active business activities.
The paper then looks at dealing with legacy Div 7A positions, including:
- Statute barred debts
- Debt forgiveness and s. 109C
- Disclaiming a trust interest
- Can a UPE be forgiven for s. 109F purposes?
- Assigning a Division 7A loan
- Assigning an existing UPE
- Section 100A.
Greg covers issues with existing sub-trust arrangements, before looking at interposed entities and distributable surpluses, including Division 7A exceptions and section 109T, and the distributable surplus.
Greg’s paper concludes that the policy objective for Division 7A is clear, and reasonable, but the provisions have evolved into something that is a major source of complexity and confusion for private groups.
He notes that there are now two sets of announced but unlegislated changes to Division 7A. On the surface these announced changes suggest that a substantiate rewrite and simplification of Division 7A is in the offing. But there is always the risk that these will become just another example of tinkering with the provisions and will fail to deliver the simplification that they promise. Time will tell.
For private groups and their advisors however, what is clear is that the landscape is changing and strategies that worked in past years will be unlikely to work into the future.
The 2018/19 year should be a year of reassessing tax strategies in anticipation of the 1 July 2019 amendments. It will also be a period for looking at legacy issues and seeing what can be unwound prior to the new legislation, and whether there will be effective ways of managing old loans and UPEs under the new legislation.
|Greg Travers, CTA|
Within all of this, Greg notes, private groups and their advisors need to keep front of mind the reality that Division 7A is one of the most common sources of tax issues in reviews of private groups and high wealth individuals, so any new strategies or actions to deal with legacy issues stand a good chance of coming under the scrutiny of the ATO.
of the Tax Services division of William Buck
in Sydney. His clients are predominantly
large private businesses, both Australian
and foreign-owned, as well as higher wealth
individuals and families.