Treasury releases new "anti-business" Division 7A proposals

By Alexis Kokkinos - October 25, 2018

After a four-year wait, the Treasury has released a discussion paper purporting to amend Division 7A in line with 2014 Board of Taxation proposals to reduce compliance costs for businesses. If legislated in its current form, there will be a substantial increase in compliance costs and tax payable by business entities within private groups conducted only for business purposes.

Instead of amending the law to reduce compliance for business taxpayers, consistent with the proposals in the government's 2016 Budget announcement, the Treasury has opted for rules that increase instances of double and even triple taxation, as well as taxation at the top marginal tax rate. The new proposals are a slap in the face for the private business tax community and contrary to recent amendments made by the same government to provide a lower tax rate to business taxpayers to assist with cash flow.

A. What happened?

Division 7A is a set of provisions governing the tax treatment of loans and other benefits provided by a private company to shareholders or their associates. Division 7A is one of the most significant compliance issues faced by private groups, especially those that operate their business using a corporate structure.

In 2014, the Board of Taxation provided a report to government outlining proposed changes to reduce compliance costs for business taxpayers seeking to apply Division 7A, while at the same time seeking to maintain the integrity of the provisions. In 2015, the current Treasurer, the Hon Josh Frydenberg, accepted those recommendations, indicating they would be positive for businesses:

“The report on Division 7A includes a number of recommendations designed to ease the compliance burden associated with rules that govern distributions from private companies and to lower the cost of working capital for private businesses.”

Unfortunately, the Treasury’s new discussion paper indicates it has decided to remove almost all proposals to ease the compliance burden and working capital costs, with implications for compliance costs and the amount of tax payable by entities within private groups.

This latter aspect is critically important. While Pitcher Partners supports integrity rules that protect the corporate tax base where private company profits are used for private purposes, the proposed amendments were intended to assist corporate taxpayers in complying with Division 7A where the profits are not used for private purposes. These recommendations were clearly accepted by the government yet have now been dismissed by the Treasury without the government stating a policy change.

The Treasury justifies its change in position as “preferred from a policy perspective as [its new approach] encourages proactive cash flow management”. It is ludicrous of Treasury to suggest that forcing private businesses to fund annual payments of cash (business loan repayments) using after-tax dollars funded at the 47% tax rate will assist in positive cash flow management. In many cases, this policy change will result in double taxation and in some cases triple taxation where the dividends cannot be franked.

Treasury also justifies its renewed positions based on reasons of “commerciality”. However, it is uncommon to see an arm’s length loan with features such as charging interest on the opening balance for the whole year (irrespective of repayments); requiring ten equal repayments over the term of the loan; having a variable interest rate (only) and no option for fixed rates; and no ability to reduce the proposed high interest rates by way of security.

The difficult aspect to fathom is that, only last week, the government brought forward a reduction in the corporate tax rate to 25% and passed this Bill through Parliament with bi-partisan support. On this, the Minister, Hon Josh Frydenberg, went on record stating:

“This means businesses will keep more of their own money – that’s money they can invest back into their business, to create jobs, to boost their productivity and grow.”

However, instead of proceeding with the original Division 7A recommendations that would assist private business in complying with the provisions and with cash-flow management issues associated with the provisions, the Treasury has reversed such recommendations and policies in the release of this discussion paper. Pitcher Partners questions whether the change in policy is deliberate, and with government support, or made by the Treasury without direct authorisation from government. Typically, changes such as these are accompanied by a statement by the government that there has been a change of policy.

The Board of Taxation review was instigated by the Hon David Bradbury in 2012 and the recommendations were developed over a two-year period by a panel of experts from the Treasury, ATO, the Board of Taxation and public practitioners. As a representative member of the panel, Pitcher Partners confirms the ideas and concepts were thoroughly tested from both a policy and revenue perspective, and were subject to a rigorous consultation process with external parties. The government accepted these recommendations in 2015. The outcome, four years after the Board of Taxation report, is unexpected. 

While Pitcher Partners will put forward concerns to government and Treasury with the release of this discussion paper, it also encourages the business community to make submissions on this issue and to outline their concerns with these proposals.

B. What are some of the significant changes?

The Treasury discussion paper takes a controversial position that will have a dramatic impact on business taxpayers that use corporate profits to fund business activities. These activities do not pose an integrity concern for the progressive personal tax system. The following table outlines some of the proposed changes.

Original proposal

Amended proposal

Comment

Loans would be for ten years, with the first three years being interest only. This was proposed to assist with lending to businesses.

Repayment will be required annually.

Treasury suggests the new model is preferred as annual payments encourage proactive cash flow management by businesses and reduce the size of payments (ten smaller payments) relative to the amortisation model.
In reality, this means a business without cash flows needs to fund this using dividends and pay tax at the top marginal rate, thus reducing cash flow even further.

No requirement for a formal loan agreement, however businesses would need to provide evidence of a loan. This would assist inadvertent breaches of the provisions based on technicalities.

No requirement for a formal written loan agreement, however, written or electronic evidence showing that the loan was entered into must exist and reference the parties to the loan;
the agreement that the loan be made, including details of the date and evidence of its execution and binding nature on the parties to the agreement;
the loan terms (the amount of the loan, the date the loan was drawn, the requirement to repay the loan amount, the term of the loan and the interest rate payable).

The document states no formal loan documents are required, however the proposed new requirements are even more onerous than the existing requirements.

Interest is calculated on the loan balance.

Interest is calculated on the opening loan balance.

No reason for the change stated.

Interest rate calculated at the overdraft rate (8.3%), coupled with a three-year interest-only period.

Interest rate calculated at the overdraft rate (8.3%), without the three-year interest-only period.

The higher interest rate aimed to compensate the revenue for the interest-only period. The Treasury has removed the three-year interest-only period but retained the higher rate of interest.
Therefore, cash-strapped businesses in a private group get access to higher profits (through a reduced corporate tax rate), but then need to access this at an interest rate that far exceeds rates obtained from financial institutions.

The rules would be subject to a distributable surplus rule.

The distributable surplus will be removed.

Removing the distributable surplus means loans that are not sourced from pre-tax profits (i.e. sourced from external loans or income that has already been subject to marginal rates) can be treated as unfranked dividends.
This can result in double, if not triple taxation, where no franking credits are provided.

Seven-year loans can be transitioned to the new regime over ten years.

Seven-year loans are to be transitioned into the new regime using the remaining life of the loan.

Complete policy change, with no explanation.

25-year loans can be transitioned into the new regime over 25 years.

25-year loans are to be placed on ten-year complying loan agreements.

These arrangements are secured loans under legally binding agreements.
The proposal ignores this and assumes taxpayers can simply amend the agreements, thus having a retrospective effect on existing transactions.

The period of review would be four years, commencing from the date of lodgement for the income year in which each milestone payment is required (or would have been required had a complying loan agreement been entered into).

It is proposed that the period of review for Division 7A transactions be extended to cover 14 years after the end of the income year in which the loan, payment or debt forgiveness gave rise or would have given rise to a deemed dividend.

Only cases of fraud or evasion are provided with a timeframe that exceeds four years. This recommendation is unjustified.

For more information about the above changes and the potential impact to your business, contact Pitcher Partners today.


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