If you want more analysis of the Treasury’s proposed changes to Division 7A in its October 2018 paper, and lots of complaints about how they have handled the process and the outcomes, I have written a paper on it that can be downloaded by clicking on the link below. Enjoy.
Remember this is just a discussion paper, but I am confident these all will occur.
Change 1 – Simplified Loans
The biggest change is that the current 7 year and 25 year loan models will be replaced by a single loan model which has the following features:
- A 10 year loan begins at the end of the income year in which the advance is made.
- The taxpayer is still given until the lodgment day of the private company’s income tax return to repay the loan or put it on complying loan terms.
- The annual benchmark interest rate will be the Small business; Variable; Other; Overdraft Indicator Lending rate most recently published by the Reserve Bank of Australia prior to the start of each income year.
- There will be no requirement for a formal written loan agreement, however written or electronic evidence showing that the loan was entered into must exist by the lodgment day of the private company’s income tax return.
- The minimum yearly repayment amount consists of both principal and interest, BUT the principal component is a series of equal annual payments over the term of the loan. The interest component is the interest calculated on the opening balance of the loan each year using the benchmark interest rate.
- Interest is calculated for the full income year, regardless of when the repayment is made during the year (except Year 1). If the loan is paid out early, that is before Year 10, interest will not be charged for the remaining years of the loan.
- Repayments of the loan made after the end of the income year but before the lodgment day for the first income year are counted as a reduction of the amount owing even if they are made prior to the loan agreement being finalised. Interest for Year 1 is calculated for the full income year on the balance of the loan outstanding at lodgment day.
Here is the Government’s example of how this will work…
Example: Calculation of the deemed dividend
Bert is the sole director and shareholder of Sesame Pty Ltd.
On 1 August 2019, Bert withdraws $100,000 from Sesame Pty Ltd to pay for the renovation of his house. Bert does not have the funds to pay back Sesame Pty Ltd by the lodgment day of Sesame Pty Ltd’s income tax return, 15 May 2021. To avoid the $100,000 being treated as if it were a dividend paid from Sesame Pty Ltd, Bert decides to put in place a complying Division 7A loan agreement.
The repayments that Bert would be required to make according to the new loan model would be as follows:
Year Interest Rate* Opening Balance
2020-21 8.50% 100,000 8,500 10,000 18,500 90,000 2021-22 7.00% 90,000 6,300 10,000 16,300 80,000 2022-23 6.50% 80,000 5,200 10,000 15,200 70,000 2023-24 8.00% 70,000 5,600 10,000 15,600 60,000 2024-25 9.00% 60,000 5,400 10,000 15,400 50,000 2025-26 8.25% 50,000 4,125 10,000 14,125 40,000 2026-27 7.90% 40,000 3,160 10,000 13,160 30,000 2027-28 8.00% 30,000 2,400 10,000 12,400 20,000 2028-29 9.20% 20,000 1,840 10,000 11,840 10,000 2029-30 7.50% 10,000 750 10,000 10,750 0
*Interest rates shown are for illustrative purposes only
The interest paid by Bert each year will be taxed as income to Sesame Pty Ltd at its corporate tax rate.
- If the repayment actually made in the income year is less than the required minimum yearly repayment, a deemed dividend will arise for the amount of the shortfall between the minimum yearly repayment and the actual repayment made for that income year.
For example, the minimum yearly repayment in the above loan model example for the 2022-23 income year would be $15,200. If the actual repayment made in the 2022-23 income year was $12,200, the deemed dividend would be $3,000. Bert will include this $3,000 as income for the year, and pay tax at his marginal tax rate.
Change 2 – Self-correct without telling the Commissioner
Under the proposed changes, qualifying taxpayers will also be permitted to self-assess their eligibility for relief from the consequences of Division 7A. To qualify for self-correction, the taxpayer will need to meet eligibility criteria in relation to the benefit that gave rise to the breach. The eligibility criteria will require that:
- The breach of Division 7A was an inadvertent breach;
- Appropriate steps have been taken as soon as practicable; and
- The taxpayer has taken, or is taking, reasonable steps to identify and address any other breaches of Division 7A.
Under this approach, in order to self-correct an eligible taxpayer must:
- Convert the benefit into a complying loan agreement, on the same terms that would have applied had the loan agreement been entered into when it should have been; and
- Make catch-up payments of the principal and interest that would have been payable as prior minimum yearly repayments had the taxpayer complied with Division 7A when it should have. The interest component of the catch-up payment will be compounded to reflect prior year non repayments. This compounded interest should be declared as assessable income in the private company’s income tax return for the income year in which the catch-up payment is made.
So now when you get the new client with heaps of Div7A issues you can clearly tell them how to fix it up.
Change 3 – Distributable surplus
The third major change is to the concept of distributable surplus – actually it is the total removal of the concept of distributable surplus.
This will align the treatment of dividends with section 254T of the Corporations Act 2001 which allows dividends to be paid out of both profits and capital.
And let’s be honest, if a certain amount is ‘distributed’ to the shareholder, then tax should be paid on the entire amount, and it should not be arbitrarily limited.
Change 4 – UPE argument over
After eight years of arguing with the Commissioner on whether UPE’s fall within Div 7A the argument is over as the law will be changed to say they are.
Under the proposed chnages, where a UPE remains unpaid at the lodgment day of the private company’s income tax return, the UPE will be a deemed dividend from the company to the trust or the UPE can be put on ‘complying loan terms’ under which principal and interest payments are required to be made.
All UPEs arising on, or after 16 December 2009 and on, or before, 30 June 2019, that have not already been put on complying loan terms or deemed to be a dividend, will need to be put on complying terms by 30 June 2020. The first repayment for such loans would be due in the 2019-20 income year. Any amounts outstanding that have not been put on complying loan terms by the end of the 2019-20 income year will result in a deemed dividend for the outstanding amount of the UPE.
All UPEs that arise on, or after, 1 July 2019 will need to be either paid to the private company or put on complying loan terms under the new 10 year loan model prior to the private company’s lodgment day, otherwise they will be a deemed a dividend.
Effectively, from 1 July 2019 there will be no argument… a UPE is the same as a loan.
There are lots of other proposed changes that will not be as relevant as these four changes and we can consider these later. But from these four main changes…
From 1 July 2019:
- If you find a Div 7A problem, you just fix it by paying what you missed;
- I don’t need written loan agreements;
- You don’t need to do distributable surplus calculations;
- UPEs to corporate beneficiaries are just treated like loans from the company to the trust;
- I pay the same principal off each year, 1/10thof the initial loan;
- The interest is just the Small business; Variable; Other; Overdraft Indicator Lending rate most recently published by the Reserve Bank of Australia prior to the start of each income year; and
- I pay off the loan over 10 years in every case.
Not as massive a change as we hoped, but a good start.
On Budget night in May the Treasurer indicated there would be changes from 1 July 2019 that would deny some deductions for expenses related to holding vacant land. In Exposure Draft – Treasury Laws Amendment (Measures For A Later Sitting) Bill 2018 we finally have an idea of what they are going to stop us claiming deductions on.
While that exposure draft proposes to deny deductions for expense incurred to the extent they relate to holding vacant land, they do not apply to expenses relating to holding vacant land to the extent they are incurred in a business the that taxpayer, or an affiliate, spouse or child of the taxpayer carries on. They also do not apply to companies, superfund that are no SMSFs and entities used by institutional investors in residential premises.
Expenses that are not deductible are included in the cost base of the asset for CGT purposes.
But what is vacant land?
“no building or other structure on the land that is substantial and permanent in nature and in use or ready for use”.
Chelsy owns a block of land. She intends to eventually build a rental property on the land. However, while the block of land is fenced and has a large retaining wall, it currently does not contain any substantial or permanent building or other structure. As the property does not have a substantial permanent building or structure on it, it is vacant land and Chelsy cannot deduct any holding costs she may incur in relation to the land.
If there are vacant parts of land you need to reasonably attribute expenses to the vacant, and other, parts of the land.
Howard owns a country house with a pool on a hectare of land in Queensland. He uses one third of the land for carrying on his firewood sales business. His house and firewood business are separated by a fence and the remainder of the land is unoccupied and unused. Howard intends to build a rental property on the unoccupied land.
Howard is eligible to claim losses and outgoings relating to holding the part of the land that he uses for carrying out his firewood business, to the extent that the loss or outgoing is necessarily incurred for the purpose of gaining or producing the assessable income from the business. He cannot deduct any expenses associated with the cost of holding the land on which his country house is built because that part of the land is used for private use.
The remainder of his land is unoccupied and is not used in carrying on his business and therefore Howard is not entitled to claim any deductions relating to the costs of holding this part of the land even though he intended to derive income from it in the future.
Deductions are not denied if you are carrying on a business, like property development or primary production.
Ainslie carries on business as a property developer and owns a significant property portfolio of vacant land in Melbourne. She incurs outgoings relating to holding the vacant land including interest payments and council rates. As she incurs the expenditure to hold the land in carrying on her business for the purpose of producing assessable income it is deductible.
Gina owns vacant land in New South Wales which she rents to her spouse Robin for use in a farming business he carries on. Robin, as Gina’s spouse, forms part of the class of related parties (spouses, children under 18 years old, affiliates and connected entities) that allow Gina to deduct her costs of holding the land. This is because Robin is carrying on a business on it to produce assessable income.
Finally, there is a special rule applies to land that contains residential premises within the meaning of the GST Act. Such structures are disregarded and the land is treated as remaining vacant for the purposes of these amendments until the residential premises are able to be occupied under the law and are leased, hired or licensed or available for lease, hire or licence.
Anna purchased a block of vacant land and built new residential premises on it. Occupancy permits are issued for the residential premises once the building is considered suitable for occupation. The building is available for lease and advertised in various property websites which give it broad exposure to potential tenants. Anna can deduct the cost of holding this block of land to the extent expenses relate to the period when the property is legally available for occupation and is leased etc or otherwise available for lease etc.
The summary, no probs for property developers… but what if you are not quiet yet a property developer…
But not for a few years…
As we have previously discussed here, there are two company tax rates. They are 30%, or if the company has an aggregated turnover under $50m ($25m last year) and has less than 80% of its income from “base rate passive income”, the rate is 27.5%.
In the Treasury Laws Amendment (Lower Taxes For Small and Medium Businesses) Bill 2018 ONLY the rate of 27.5% changes. The same companies are eligible for the lower rate, but that rate will be:
– 26% from 1 July 2020; and
– 25% from 1 July 2021.
So the difference between to top marginal rate and the company rate for small and medium businesses goes to 22%. That is not going to encourage warehousing income in companies??? More PSI cases and more Div 7A ideas…
This Bill also increases the Small Business Income Tax Offset to 13% from 1 July 2020 and 16% from 1 July 2021… But as this offset is capped at $1,000 from 1 July 2021, if you have more than $6,250 of income from your small business, the 16% rate gets you to $1,000.
We now have Exposure Draft legislation that proposes to prevent the small business CGT concessions from being available for assignments of the income of a partner and other rights or interests in the income or capital of a partnership that are not a membership interest in the partnership.
Since the 1980 High Court decision in Everett, partners can make an assignment of some of their interest in the partnership. Such an assignment does not make the assignee a partner but means that the partner holds the partnership interest on trust for the assignee and the income is taxed to the assignee. These assignments result in a CGT event and the small business CGT concessions can be used to reduce any resulting capital gain.
Under these new rules, the small business CGT concessions remain available for genuine disposals and transactions that affect the substance of the operation of the partnership.
However, they are not available for assignments and other rights or interests that merely result in the transfer of income or capital that a partner receives from the partnership to other entities without making the other entity a partner.
Laura, a partner in a partnership, makes an equitable assignment of half her partnership interest to Dominic, her spouse. This entitles Dominic to half of any amounts Laura receives as a partner, but does not make Dominic a partner.
The assignment results in Laura having a CGT event. The CGT event involves both the variation of Laura’s partnership interest and the creation of a right in the hands of Dominic.
Both interests entitle the entity holding the interest – Laura for the partnership interest, and Dominic for the right to income – to an amount of the income and capital of the partnership. As a result, both interests must satisfy the additional basic condition for the small business CGT concessions to be available for the CGT event.
The partnership interest held by Laura is a membership interest of Laura’s in the partnership and satisfies the condition. The equitable interest held by Dominic is not a membership interest of Dominic’s and cannot satisfy the condition.
As Dominic’s interest does not satisfy the new additional basic condition, the small business CGT concessions are not available to Laura in relation to the CGT event.