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Division 7A: the saga continues

Tax Telegraph, February 2013

Division 7A: the saga continuesDivision 7A of Part III of the Income Tax Assessment Act 1936 was introduced in 1997 with the purpose of ensuring that profits of private companies are not paid to shareholders (or their associates) without being subject to the appropriate rate of tax.

Since its introduction, Division 7A has undergone numerous amendments. However, a number of these amendments have not only increased its complexity and added unintended consequences, but have also raised a great deal of controversy.

On 18 May 2012, an announcement was made by the Assistant Treasurer that the Board of Taxation (the Board) will examine the effectiveness of Division 7A and assess whether there are options to simplify the area of law.

The Board is required to conduct this review in line with the following terms of reference, and:

  • Examine whether Division 7A gives effect to its policy intent
  • Examine whether there are any problems with the current operation of Division 7A, including its interaction with other areas of the tax law, that are producing unintended outcomes or disproportionate compliance and administration costs
  • Recommend options for resolving these problems so that the tax law operates effectively.

The Board is also required to examine the potential for broader reforms to Division 7A, including whether the provisions could be expressed in a clearer and simpler manner. Any reforms will need to maintain the integrity of the tax law and revenue neutral or near revenue neutral outcomes. 

The Board is expected to complete its review by 30 June 2013.

Discussion paper

On 20 December 2012, the Board of Taxation released a discussion paper on the post-implementation review of Division 7A.

The purpose of the discussion paper is to invite public submissions and facilitate stakeholder consultation on the issues identified by the Board.

Submissions on the discussion paper are due by 15 February 2013. Deloitte will be providing its comments to the ICAA, which will be forwarding a joint submission from various entities including Deloitte, to the Board of Taxation.

Problems identified

Broadly, the discussion paper identifies the following provisions as problematic:

  • Subdivisions A and AA: Since the extension of Division 7A to certain corporate limited partnerships, new arrangements have been identified whereby taxpayers have introduced entities that are not private companies but are companies or taxed as if they were companies for tax purposes. Also, despite the introduction of section 109BC, there is still uncertainty as to whether Division 7A applies to cases involving both non-resident shareholders and non-resident private companies with Australian sourced profits

  • Subdivision B: There are several issues relating to the exclusions for payments, loans and debt forgiveness transactions

  • Subdivision C: There are inconsistencies between exclusions which are available under Subdivision C (subsections 109G(3) and (3A)) for certain kinds of debt forgiveness

  • Subdivision DB: In relation to the Commissioner’s general discretion to disregard the operation of Division 7A in respect of loan repayments, section 109RB is silent on the remedies available to taxpayers dissatisfied with the decision or non-decision by the Commissioner

  • Subdivision EA: There are differing views as to whether an unpaid present entitlement (UPE) is a loan for Division 7A purposes, despite the ATO’s position in TR 2010/3 that UPEs may be treated as loans in certain circumstances. In particular, it has been discussed whether there is a need to clarify the circumstances in which a UPE should be treated as a Division 7A loan and, if so, how that clarification should be provided. Additionally, it is proposed that the question of whether UPEs should be treated as financial accommodation for the purposes of Division 7A should also be resolved, and, if so, at what point in time.

Division 7A reform considerations

The following approaches to reform have been put forward in the discussion paper:

  • Address the individual issues and problems in Division 7A by way of specific legislative amendment
  • Largely replace Division 7A with a requirement that loans to related entitles carry a statutory rate of interest, but with no requirement that principal be repaid prior to termination of the loan
  • Allow the retention of profits within the private group for permitted purposes and to treat any profits unused and not distributed, as deemed dividends.

Editor’s comments

Addressing individual issues and problems with Division 7A with legislation means that, the rectification of the problems will take a significant period of time. Some interim measures would need to be considered in the meantime and you would query how many scenarios could be covered off by such amendments. This process is likely to create more lengthy and complicated legislation.

Clearly the treatment of UPEs and loans under Division 7A needs to be clarified, including reconciling Subdivision EA with the idea that UPEs are loans.

In the Editor’s view, the proposal that the profits of companies be retained only for permitted purposes would also be a step backwards and inappropriate.

In our view, the proposal to replace Division 7A with a requirement that loans carry interest and no requirement to repay the principal sum until termination of the loan has merit. It keeps the changes simple and would appear most equitable. Why should companies in private groups be allowed to obtain an interest only loan from a third party financier but not be allowed to obtain a loan on similar terms from another private company in their own group?

What’s next?

The numerous amendments to Division 7A have increased its complexity and added unnecessary complications to the provisions. The announcement by the Treasury regarding the review of Division 7A as to its effectiveness and the subsequent release of the discussion paper by the Board of Taxation appears to be a positive step in the right direction.

These are still early days; however, it is hoped that these positive steps will result in some clarity to Division 7A and bring it back to its original policy intent.

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