Posted on August 29, 2022 by Kelsi Keep
If you own a closely held private company, you have probably heard your accountant talk about Division 7A at one point or another. If you had no idea what your accountant was talking about this article covers the background of why division 7A was brought in and what it’s effect is on the drawing of after tax profits from a private company.
Background
When Division 7A of the Income Tax Assessment Act 1936 (ITTA 1936) was introduced in 1997 the tax rate for companies was significantly less than the top marginal rate for individuals + Medicare levy.
Drawing a dividend from a company would trigger a top-up tax liability where the shareholder’s individual tax rate was higher than the company rate. (eg. 36% company tax rate vs 47% top marginal rate for individuals including Medicare)
This created an incentive to draw the company’s after tax profits (or unrealised profits) in the form of a loan, rather than a dividend for closely controlled private companies (where there were no third party shareholders or directors to complain) to avoid paying the top up tax.
Section 108 of the ITAA 1936 was the integrity provision intended to prevent shareholders from drawings funds from private companies tax free.
This section relies on the Commissioner forming the opinion, after either a voluntary disclosure or audit activity, that a loan or other advance or crediting should be deemed to be a dividend if it could not be proven that at some stage the loan was going to be repaid.
Usually, there was no real intention of repaying such loans, and with no further tax liability, the shareholder accordingly enjoyed the extra funds.
Division 7A was introduced to fix this situation, replacing its predecessor, section 108 ITAA 1936.
What is Division 7A?
Under section 109D ITAA36, a private company is deemed to have paid an unfranked dividend (limited to the company’s distributable surplus) if it makes a loan during an income year to a shareholder (or associate), that is:
- not fully repaid before the “lodgement day” (the earlier of the company’s tax return due date or the date the company tax return is lodged) for that year; and
- not one of the types of loans that Division 7A(D) excludes from being treated as a dividend
The excluded loan that we are interested in here is that covered by section 109N ITAA 1936.
This provision sets out criteria for the loan which, if met, will result in the company not being taken to have paid a deemed unfranked dividend in that income year.
The criteria are:
- the loan terms are defined in a written agreement that is executed before the company’s “lodgement day”;
- the interest rate on the loan for income years after the one in which the loan was made is equal to or greater than the benchmark interest rate for each year; and
- the maximum term of the loan is seven years (unsecured) or 25 years (secured)This exclusion from being treated as a dividend also applies where a trust has an unpaid present entitlement (UPE) owing to a private company, and the trust makes a loan to a shareholder (or associate) in that company.
Section 109E requires that minimum annual repayments are made each year after the one in which the loan was made for excluded loans.
The reality is that minimum annual repayments are rarely paid by transferring money.
An effective way to make a cashless repayment is to offset a dividend declared by the company against the loan. Each party (lender and borrower) makes a legally effective payment to the other, without the need to transfer any money.
Proposed Legislation Changes
The 2016 Federal Budget announced that the government will make targeted amendments to improve the operation and administration of Division 7A. These changes will provide clearer rules for tax payers and assist in easing their compliance burden while maintaining the overall integrity and policy intent of Division 7A.
The start date has been delayed over the years and has now been revised to be from 1 July 2020 to income years commencing on or after the date of Royal Assent of the enabling legislation.
Watch this space for further information once legislation has been drafted and we have a clearer idea of what the changes will entail.
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Posted on April 11, 2022 by Ashley Dawson
Recent changes to the way trust distributions will be assessed by the ATO could have a major impact on the tax planning decisions of many family groups, especially those with adult children. In this article we explore those changes and outline some of the challenges they pose for trustees and their advisors.
Where we came from
On 23rd February 2022 the Australian Taxation Office released a draft tax ruling (TR 2022/D1) updating their interpretation of the tax law surrounding distributions made by family trusts. They also released a guide on how taxpayers can best comply with this updated interpretation (PCG 2022/D1). The specific section of the income tax law covered by these documents is s.100A of the Income Tax Assessment Act 1936.
Section 100A is an integrity provision aimed at preventing trustees from making a beneficiary entitled to trust income without also transferring to them the financial benefits of that entitlement. Under the legislation the distribution can be deemed invalid where it is determined the intention of the distribution was to gain a tax benefit by distributing profits to a beneficiary on a lower income tax rate than the person(s) who ultimately receive the financial benefits. The provision also targets scenarios where the profits are retained in the trust and a beneficiary with a lower tax rate than the person(s) who control the trust is made entitled to the retained profits. In both scenarios, the key facts are:
- That the beneficiary who is made entitled to the distribution does not receive the financial benefits of the distribution,
- Making the beneficiary entitled to the distribution will achieve a better tax result than making the person(s) who received the financial benefit entitled to the distribution,
- There is a connection between the entitled beneficiary and the recipient of the financial benefits, and
- The arrangement made is inconsistent with ordinary dealings between such parties.
In practice, the above normally refers to a situation where a beneficiary of a trust is made entitled to a distribution for income tax and trust law purposes, however no funds are transferred to the beneficiary. Instead, the beneficiary will allow another person, generally a family member, to make use of the funds either within the trust (in the case of retained profits) or to fund their own personal expenses (an offsetting arrangement).
Previously such arrangements could be managed within family groups by either offsetting historical expenses against a future trust entitlement or using ‘love and affection’ letters. When offsetting historical expenses, a trustee (typically a parent) would record the cost of expenses they paid for a person (typically a child) and in the future make the person entitled to a trust distribution equal to the expenses paid. Common expenses included education, sports and board. Love and affection letters achieved a similar result, however rather than offset the distribution against expenses the beneficiary instead gifted their entitlement to another person (typically a child gifting their entitlement to a parent). The other person would then use the beneficiary’s entitlement to offset funds they had drawn out of the trust to fund their lifestyle. Both arrangements hinged on the idea that is ordinary for families to share wealth and benefits and therefore the distributions did not meet the condition noted at point 4 above. Therefore, s100A did not apply.
Where we are now
In drafting TR 2022/D1 the ATO have expressed a very narrow view of what constitutes ordinary family dealings. They have noted that:
- Arrangements that could be covered by s100A are not excluded from its operation simply because the parties are all from the same family,
- Arrangements that appear to be driven by tax outcomes as opposed to family objectives cannot be excluded from s100A, and
- The fact that such arrangements are widespread in the community is not a valid defence against the operation of s100A.
This narrow view greatly restricts the kind of arrangements that are outside the scope of s100A. If we specifically consider the offsetting arrangements and love and affection letters discussed previously, the ATO’s opinion is that it is not normal for parents to seek to recover the cost of raising children from the children themselves and that these costs are instead being recognised only to achieve a tax outcome. In considering love and affection letters the ATO’s opinion is that it is not normal for families to make substantial gifts of cash and that once again these arrangements are being entered into solely to achieve a tax outcome.
In PCG 2022/D1 the ATO have gone further and given examples of scenarios they consider to be in the green (low risk), blue (medium risk) and red (high risk) zones. A scenario that falls within the green zone has no risk of compliance action from the ATO, a blue zone scenario risks further questions and follow up from the ATO to justify the actions taken and a red zone arrangement is all but certain to trigger the application of s100A and potentially further audit activities.
Key examples that fall into the red zone are:
- An adult child is made entitled to a trust distribution and gifts the amount to their parents to repay costs such as school fees and extra-curricular activities from prior years
- An adult child is made entitled to a trust distribution and gifts the amount to their parents to be deposited into an account they control or used to offset their loan account with the trust.
Examples of arrangements that would fall into the blue zone include:
- An adult child of the trustee is made entitled to a trust distribution and this entitlement is offset against board paid to live at home at an arms-length value
- An adult child of the trustee is made entitled to a trust distribution and this entitlement remains unpaid and owing to the child. The funds are used within the trust to fund working capital
- An adult child of the trustee is made entitled to a trust distribution and this entitlement remains unpaid and owing to the child. Rather than draw on the entitlement, the adult child gifts the entitlement back to the trustee to use within the trust.
Other arrangements, particularly where the distribution made to an adult child is offset against future expenses such as university fees, the purchase of a car or computer, or other items not normally covered by the child-parent relationship, are not as falling within the green zone.
In practice the ATO is effectively killing the use of offsetting arrangements and love and affection letters by making these changes. Both tools were widely used across the community by family groups to manage their tax affairs and preserve wealth within the group.
Our Assessment
Despite being a draft ruling at this stage we consider it reckless to act outside of the recommendations in the ATO’s updated interpretation of s100A. These changes significantly reduce the potential for families to manage their tax affairs through trusts and some groups will need to rethink their tax planning strategies. Families that continue to arbitrarily split income with adult children are at real risk of being reviewed or audited by the ATO and, should this draft ruling be finalized without significant changes, will have little to no defence for their actions. Regarding the recent comments from parliament that suggest governments from either side of politics will review s100A in light of the ATO’s announcement, we are hopeful this will bring clarity to the issue but in the meantime continue to encourage caution in how families approach the issue. Ministers on both sides of politics noted that the ATO may be straying into policy development with its recent actions and that this was the domain of the parliament only. They also noted that s100A was potentially being applied to arrangements it had never been intended to target and that the level of public concern warranted a prompt response. Based on these comments we are hopeful action will be taken on the issue shortly after the upcoming federal election.
Over the past week we have been contacting our affected clients to discuss how the changes impact their family specifically. Aside from discussing the personal impact of these changes with clients, we have also been hard at work developing a series of strategies to allow families to manage their affairs firmly within the bounds of s100A. If you have further concerns about how these changes affect your personal situation, please contact us and we are happy to help you plan any necessary changes prior to 30 June 2022.
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