Tax Rambling

On 24 May 2018, the Government introduced the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Bill 2018, proposing a Superannuation Guarantee Amnesty, so that if you let the Commissioner know of any unpaid super all the way back to 1992, and make the payment by 23 May 2019, the payment will be deductible and the $20 per employee per period penalty will not apply.

As at 6 December 2018, our hard working parliamentarian concluded for the year, but they were too busy to enact this Amnesty bill. The Bill had made it to the Senate so all we need is approval from the Senate.

But how many days will the Senate sit before 23 May 2019, when the amnesty runs out? The Senate will sit on 12, 13 and 14 February and then not again until 13, 14, 15 and 16 May.

If you have a client who missed some super, you won’t want to miss this Amnesty, but if the Senators cannot approve the Bill as it is without any changes, it will go back to the House of Reps and return for final approval in mid May.

It looks like you will have 10 days (16 May 2019 to 23 May 2019) to tell the Commissioner of the underpayment and make the payment with certainty of the penalty…

The Commissioner has released a draft Ruling (LCR 2018/D10 Non-arm’s length income – expenditure incurred under a non-arm’s length arrangement) on the proposed amendments to section 295-550 so that the non arms length income rules for super funds will apply to a scheme where a superannuation entity incurs non-arm’s length expenditure, or where expenditure is not incurred.

How will these rules work…

Example 1 – purchase less than market value and no in-specie contribution – NALI

During the 2018-19 income year, Russell, as trustee of his self-managed superannuation fund, purchased listed shares from a related entity for $500,000. The market value of the shares at the time of purchase was $900,000. The terms of the agreement specifies the purchase price as $500,000, rather than $900,000.

The non-arm’s length dealing between Russell’s SMSF and his related entity amounts to a scheme, which has resulted in his superannuation fund incurring capital expenditure that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The capital expenditure was incurred in gaining or producing the dividend income. Any dividend income derived by the superannuation fund from the shares will be NALI.

This seems simple but can get very messy… Have a look at how the Commissioner see this change applying to work done by the Trustee/Member of the SMSF in relation to the assets of the fund…

Lucky the Commissioner like accountants…

Example 4 – Internal arrangement within an SMSF – trustee provides services to the fund

Leonie is a trustee of an SMSF of which she is the sole member. She is a chartered accountant and also runs an accounting business. Leonie in her capacity as trustee, prepares the accounts and annual return for the fund. As she performs these duties or services as trustee of the SMSF, she does not charge the fund for this work.[18] The NALI provisions do not apply as the duties or services performed by Leonie are in her capacity as trustee rather than under an arrangement in which parties are dealing with one another on a non-arm’s length basis.

Example 5 – SMSF trustee carrying out duties in their personal capacity

Sharon is a trustee of an SMSF of which she is the sole member. She is a licensed real estate agent and runs a real estate business which includes property management services for rental properties. The SMSF holds a residential property which it leases for a commercial rate of rent. Sharon provides property management services in her personal capacity to the SMSF with respect to the residential property. She charges the SMSF 50% of the price for her services that she would otherwise charge a non-related party.

For the purposes of subsection 295-550(1), the scheme involves the SMSF obtaining the services from Sharon and deriving the rental income. The price Sharon charges the SMSF constitutes a non-arm’s length dealing between the SMSF and Sharon, which resulted in the SMSF incurring expenditure in gaining or producing rental income that was less than would otherwise be expected if those parties were dealing with each other at arm’s length in relation to the scheme. The rental income derived from the residential property is therefore NALI.

It is not all bad news. In this draft Ruling the Commissioner states how we can overcome some of these non arms length expense issues when buying assets by treating the difference as an in-species contribution…

Example 3 – part purchase/part in-specie contribution at market value – not NALI

During the 2018-19 income year, Nadia owns commercial premises that she leases to a third party which use the premises to carry on a business. The commercial premises have a market value of $500,000. Nadia would like to transfer it to her SMSF but her fund only has $400,000 in cash. Nadia’s SMSF purchases 50% of the commercial premises under a contract from Nadia for $250,000. Nadia makes an in-specie non-concessional contribution of the remaining 50% interest in the commercial premises (valued at $250,000). The acceptance of the in-specie contribution by Nadia as trustee of the SMSF is recorded by her in writing and the market value of the in-specie contribution is reported in the fund’s accounts. The SMSF reports the non-concessional contribution to the ATO.

Nadia’s SMSF continues to lease the commercial premises to the third party at a commercial rate of rent. As the commercial premises were acquired by the SMSF at market value and a commercial rate of rent was charged, the rental income derived by the SMSF is not considered to be NALI. Any capital gain that might arise from the disposal of the factory will also not be NALI.

Lastly, remember that where a superannuation fund acquires a CGT asset at less than its market value, the market value substitution rule will apply, and modify the cost base of the asset. The superannuation fund, when determining the cost base of its CGT asset, is treated as having acquired the asset at market value. This affects the amount of any capital gain that may arise from a later CGT event, but does not affect the application of the NALI provisions in determining whether the asset was acquired by the fund at market value.

Therefore, any capital gain that the fund makes from a subsequent CGT event happening in relation to the asset (such as a disposal of the CGT asset) will be Non Arms Length Income.

Example 7 – market value substitution rules (CGT consequences for the transferor and the fund)

Continuing with Example 1 above, Russell’s SMSF sells the shares it acquired for $500,000 for $1 million two years later.

When calculating the capital gain for the fund on disposal of the shares, the cost base of the shares will be modified by the market value substitution rule in section 112-20[20] as the parties did not deal with each other at arm’s length in relation to the acquisition.

This means that the cost base for the shares will be their market value at the time of acquisition by Russell’s SMSF, which was $900,000. The SMSF has therefore realised a gross capital gain of $100,000 ($1 million sale proceeds less deemed cost base of $900,000).

The $100,000 capital gain derived by the superannuation fund is NALI. This is because the amount of expenditure incurred by the superannuation fund in acquiring the asset was less than what the superannuation fund might have been expected to incur if the parties were dealing with each other at arm’s length.

Ouch!

I doubt there are any, but if there are any regular readers of this crazy blog, they will know I have for many years screamed at the argument that Australia can fix its public finances if only those evil big businesses paid their fair share of tax.

And yes, I have been gloating that this argument started to crumble when the Commissioner early last year stated that the underpayment of tax by these businesses was only $2.4 billion a year. Remember that the underpayment of tax by salary and wage earners due to dodgy deductions or undeclared cash payments is $8.7 billion a year.

But it just keeps getting better…

Remember that the “large corporate group income tax gap” is the difference between the total amount of income tax collected and the amount the Commissioner estimates he would have been collected if every one of these taxpayers was fully compliant. And while the tax gap for salary and wage earners is mostly dodgy deductions ($7.3 billion a year underpayment of tax due to these), the “large corporate group income tax gap” primarily reflects differences in the interpretation of complex areas of tax law.

Have a look at what has been happening to this gap, while the salary and wage earner gap just keeps increasing…

The income tax gap for these large corporates is going down. And there is no wonder why. The multinational anti avoidance law, the diverted profits tax, country by country reporting, hybrid changes…

But watch the number of lobbyists and politicians, wanting money from a new government after the May election, saying that it all can be funded by making those evil big businesses pay their fair share of tax, which they already do…

But no one will dream about addressing the issue that is almost 500% bigger – salary and wage earners and their dodgy deductions.

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.

Division 7A to change

The Government has promised a series of changes to Division 7A and we have finally got an idea of what these changes will be. 

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:

1. A 10 year loan begins at the end of the income year in which the advance is made.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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 $	Interest Amount $	Principal Amount $	Minimum Repayment $	Closing 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.

Summary

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:

1. If you find a Div 7A problem, you just fix it by paying what you missed;
2. I don’t need written loan agreements;
3. You don’t need to do distributable surplus calculations;
4. UPEs to corporate beneficiaries are just treated like loans from the company to the trust;
5. I pay the same principal off each year, 1/10^thof the initial loan;
6. 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
7. 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”.

Example

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.

Example

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.

Example

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.

Example

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.

Example

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.