TaxRambling.com

Sorry but I had to much thinking time over the Christmas holidays…

Many tax agents have a story of a new client where, sitting on the balance sheet of a private company in the group, there are loan accounts to shareholders or their associates. While this in itself is not a problem, the tax agent then looks for the minimum yearly repayments and section 109N loan agreements required under Division 7A for these amounts not to become deemed dividends, only to find there are none.

A common example of this problem is the loan is not to the actual shareholder of the private company, but to a trust that is a “associate” of the shareholder. Often the trustee of the trust is a company and so it looks like the loan is between two companies and so not subject to Division 7A – but it is as the loan is actually between the trust and the company.

Division 7A compliance is, anecdotally, not robust, and many of the times Division 7A is not complied with are merely just mistakes, rather than some scheme to access cash that is only taxed at the company tax rate, which is the underlying purpose of this anti avoidance provision.

Therefore, it is worth considering is there a better way to make it so that non-companies cannot utilise funds only taxed at the company tax rate than is done under the current Division 7A?

MAKE EVERY PAYMENT BY A PRIVATE COMPANY THAT IS NOT FOR GOODS AND SERVICE, A DIVIDEND OR A RETURN OF CAPITAL SUBJECT TO A NEW ANTI AVOIDANCE PROVISION 

A company can only get “value” out of itself to another entity in a few ways. It can:

1. Pay for goods and services (including salaries and wages to employees and directors);
2. Pay dividends;
3. Return capital;
4. Allow others to use its assets (yes I know this is in effect a loan/gift); or 
5. Make a loan or gift.

The last two options above are the places that we need to look at see if the current Division 7A applies. However, it only applies in specific situations and does not apply in others, like a gift to a charity or a loan at a commercial rate or a loan between companies or a loan from a company with no distributable surplus or… and the list goes on and on. This often causes confusion and so we should consider simplifying when the anti avoidance provision applies.

2.1          When should this new anti avoidance provision apply?

To make the threshold question easier to establish when an anti-avoidance provision like Division 7A applies there should be a simpler question. Something like:

Is the payment made by the private company, or use of an asset owned by a private company:

• A payment for goods and services at market value (including salaries and wages to employees and directors); 
• A dividend; or 
• A return of capital? 

If not, this new anti-avoidance provision replacing Division 7A may apply. All of these three payments in the above are appropriately taxed in the hands of the recipient and so don’t need to be covered by this new anti avoidance rule.

2.2          What about exemptions and anti avoidance measures that currently exist in Division 7A?

Then, once all payments outside for these three types of payments are identified, we then need to consider if there are payments that should be exempt. Examples of exempt payments should include gifts made to charities, non for profits and non related parties.

Other exemptions might include payments to another company (like section 109K) or payments made as a part of the company’s business on similar terms (like section 109M), but these may not be needed given the proposed action of the new anti avoidance provision suggested in the following section.

This removes the need to consider who are the shareholders or associates of shareholders and the only challenge is assessing if a gift is made to a non related party, which would be very uncommon.

MAKE EVERY LOAN/GIFT MADE BY A PRIVATE COMPANY SUBJECT TO A NEW ANTI AVOIDANCE PROVISION THAT DOES NOT CREATE DEEMED DIVIDENDS, BUT RATHER CREATES DEEMED INTEREST

Under the current Division 7A there are effectively two outcomes when there is an arrangement that Division 7A applies to. The first is that if Division 7A applies and the taxpayer does nothing, it becomes a deemed dividend. The second is when the taxpayer does not “do nothing” and instead makes it a complying loan, the company is repaid principal and is paid interest and returns the interest as assessable income.

So why don’t we just have one possibility, whether the taxpayer does something or not. For example, why not just have the outcome of this new anti-avoidance provision applying that the amount under this new anti avoidance rule is treated as a deemed loan, there is a deemed interest rate applied to the loan and a deemed interest payment made, making the company have to pay tax on the deemed interest. 

There is no need for written agreements, and returns are always prepared as if any payment from a private company that is not for goods and services, is not a dividend, is not a return of capital and is not one of a limited number of exemption is a loan on which interest is paid.

Note that as this is not a deemed dividend the idea of distributable surplus is not needed.

There could be the possibility to require both principal and interest payments similar to the current division 7A but I believe a simpler and better idea is to allow this to be a deemed interest only loan, where this deemed interest is applied each year on the actual balance until the payment from the private company is repaid.

Whether any interest is actually paid or not, this deemed interest is added to the companies assessable income.

Actual interest payments made reduce the deemed interest added to the companies assessable income. Actual repayments of principal reduce the deemed loan. Also a deemed loan cannot be forgiven so deemed interest continues until actual repayments are made even if the actual loan is forgiven (or one of the reasons where Division 7A does not apply to a debt forgiveness like bankruptcy is the reason the loan is forgiven).

We want to encourage the payment of actual interest on these amounts and this will/can be done by the franking system and our choice of rates.

What happens if a company does not make actual interest payments and just pays tax on the deemed interest each year? Over time they build up a large franking trap, where they have substantial franking credits caused by the tax on the deemed interest, but have no cash to pay out a dividend, due to no interest actually being paid. 

Another way to encourage actual interest repayments is to have a penalty interest rate for deemed interest. For example, if during the current year a private company has made a payment that is not for goods and services, a dividend or a return of capital to an entity of $100,000, the company is treated as if it received interest in that year of say $10,000 (10% deemed interest rate). But if the entity pays actual interest during the year, or up to when the company tax return is lodged, the deemed interest rate is reduced by 2x the actual interest paid. So if the entity pays $5,000 in interest, the deemed interest reduces to zero. 

Actually paying interest on these amounts taken from private companies reduces tax payable by half, compared to deemed interest applying (and actually can delay the tax payable by a year as deemed interest is assessable in the year the amount leaves the private company, while actual interest can be paid in the next year, up to the lodgement of the return, so it will be assessable one year later).

Finally, this deemed interest problem never goes away if it is ignored by taxpayers and every year until they repay the amount tax is payable by the private company.