PVW PARTNERS SUBMISSION- DIVISION 7A INTEGRITY RULES PROPOSED AMENDMENTS
7th December 2018
Submission to the Australian Government on Targeted Amendments to the Division 7A Integrity Rules Consultation Paper, October 2018
PVW Partners welcomes the opportunity to make a submission on the proposed amendments to Division 7A of the Income Tax Assessment Act 1936 (ITAA36)
PVW Partners is a locally owned and operated Townsville based firm providing taxation and business advisory solutions for every stage of business growth and development. We believe in the potential of regionally based Australian businesses to make a strong contribution to the national economy and are proud of the role we play in the growth journey for many North Queensland family owned businesses.
PVW Partners advises over 500 privately owned businesses and family groups. We estimate up to half of these private client groups may be affected in some way by the proposed Division 7A amendments.
While we agree with the general approach to simplifying the Division 7A provisions and suggested transitional timeframes, we are concerned about certain adjustments and an element of retrospectivity around the changes.
We also believe that both major political parties’ focus on specific areas of tax change is only serving to distract from a broader tax reform agenda.
Former Minister Allan Rocher stated in Parliament when discussing the Bill that introduced Division 7A in 1998, “It is clear that the amendments proposed here are consistent with the ongoing attack by Treasury and the ATO on perfectly legitimate trust structures… I restate my long-held position that, until Australians embrace a thorough overhaul of our tax system and until there is greater parity between the top marginal personal income tax rate and the company tax rate, vehicles such as trusts will always pose a potential threat to revenue.”
The case for a thorough overhaul of the tax system is stronger now, as the gulf between the top marginal tax rate of 47% and the company tax rate will have doubled from 11% to 22% by the time the company tax rate for base rate entities reduces to 25% in the near future.
One must also keep in mind that the choice of specific entities or choice of broader structures should not be made with just taxation outcomes in mind. There are a range of commercial and legal reasons why various structures are implemented and taxation policy should enable and facilitate the use of appropriate structures and not unduly discriminate against legitimate structuring decisions.
Simplified Loan Rules
Overall, we welcome the general approach to simplifying Division 7A loan arrangements. We note the change in benchmark interest rate to the Small business; Variable; Other; Overdraft-Indicator Lending rate is a significant increase from the Housing loans; Banks; Variable; Standard; Owner-occupier rate currently applied to Division 7A affected loans. This interest effect is compounded by the application of interest to the opening loan balance for the full income year, regardless of interim payments during the year.
If we are correct in assuming that all 25-year loans will be converted to a maximum 10-year term from 2021, in our view there appears to be a degree of retrospectivity for taxpayers who entered into complying 25-year loans since 2007, with obviously greater impact for taxpayers with loan arrangements entered into more recently. We believe there should be grandfathering provisions for all loans up to and including 22 October 2018, being the date of release of Treasury’s Consultation Paper, which are managed under a complying 25-year loan agreement.
We agree that further guidance material should be provided and positions of applicability to non-resident companies, and interactions with other areas of tax law, be codified to remove the risk of ambiguity and unintended outcomes for potentially affected companies and investors.
The removal of the distributable surplus provisions is a substantive law change. The current formula for calculating distributable surplus contemplates inclusion of non-commercial items which reduces the likelihood of scenarios in which the taxable distribution is “arbitrarily limited”. We also view the alignment of the deemed dividend provisions within Section 254T of the Corporations Act 2001 (Cth) as irrelevant and problematic.
Section 254T, and other sections of the Corporations Act, limits circumstances in which a company can pay a dividend for the sake of shareholder and creditor protections, and the formula for calculating maximum dividends reflects in this.
The fundamental purpose of Division 7A, being to treat certain non-dividend distributions of profits as taxable dividends to the recipient, is fundamentally disconnected with the legislative purpose of 254T and other provisions in the Corporations Act. If alignment with 254T is the premise for this change, we anticipate the same limits on dividend payments to apply to the deeming provisions within Division 7A.
Unpaid Present Entitlements
We welcome the introduction of transitional provisions for existing unpaid present entitlement (UPE) arrangements that currently rely on the Commissioner’s guidance in PSLA 2010/4 to prevent a deemed dividend arising. The proposed implementation approach will provide certainty for taxpayers that are approaching the expiry of their existing 7 or 10-year complying loan terms and will avoid the need to rely on ATO guidelines and discretions, which may be subject to change over time.
However, we consider that UPEs used by a trust structure as a source of funding for working capital purposes should not to be subject to the operation of Division 7A. We commend Treasury for excluding pre-16 December 2009 UPEs from the proposed implementation approach and specifically consider that they should not be brought within Division 7A.
However, this approach should be extended to all UPEs used by a trust for working capital purposes.
The objective of Division 7A is to seek to protect the integrity of the progressive tax system by regulating the way shareholders can access private company profits through payments, asset use, loans and debt forgiveness. It should not extend to situations where the profits are reinvested as working capital.
Treasury has already recognised that business profits should be subject to a lower tax rate by requiring companies to derive a significant portion of their income from non-passive sources to be able to be classified as a base rate entity. Treasury has specifically considered that distributions of business income from a trust to a company retains its character in the hands of the company and may allow the company to access the lower corporate tax rate on that income. In other words, business income distributed to a company from a trust carrying on a business should be concessionally taxed. Similar concessions should be extended to the reinvestment of those profits within the business.
To remove impediments to the reinvestment of business income as working capital, the Board of Taxation in its Report to the Assistant Treasurer on the Post Implementation Review of Division 7A in November 2014 had proposed an amortisation model with an optional business income election or an interest only model. Perhaps a simpler option would be an exclusion from treating UPEs as loans if the company is a base rate entity.
This proposal would be limited to small and medium businesses, does not require any elections to be made, and would not result in additional compliance costs as the company already has to determine whether it is a base rate entity for other purposes.
Subdivision EA, which deals with payments, loans and debt forgiveness by a trustee in favour of a shareholder of a private company with an unpaid present entitlement, should be retained to prevent the access of the reinvested funds by the shareholders.
This will ensure that the UPE concession for base rate entities only applies while the funds are reinvested within the trust.
Reviewing Breaches of Division 7A
Division 7A is a complex area of taxation law affecting many small and medium sized companies in regional Australia. The self-correction mechanism appears to be a reasonable and practical recommendation, and overcomes the dilemma currently facing taxpayers as to whether to request the Commissioner’s discretion in the face of the risk that the Division 7A breach may be brought to the Commissioner’s attention but the discretion to allow the corrective action be refused.
We do not agree with the extended period of review. The Commissioner of Taxation already has the power to extend the review period for cases of fraud or evasion. We do not see the need for a special extension for Division 7A arrangements.
We agree that in certain circumstances it may be difficult to quantify gap to the arm’s length amount for use of a company asset. We welcome the introduction of this safe harbour mechanism as a fall back measure should taxpayers elect not to adopt their own calculation. We agree with the formula in principle but do suggest that basic benchmark interest rates be applied.
Our View on the Division 7A Target Amendments & Broader Tax Reform Agenda
Given a Federal Election is imminent, and the Federal Opposition has already flagged major changes to other areas of taxation law (including, but not limited to, the removal of the 12-month CGT discount, limitations to negative gearing and removal of the refund of excess imputation credits), PVW Partners has serious concerns about the combined impact of these policies if introduced at or around the same time. If there is potential to postpone any amendments until after the Federal Election, we believe it would provide greater certainty and clarity to our clients about their future and how best to restructure.
In addition to the above, we are also concerned that this legislative change will distract from a broader tax reform agenda. The proposed changes to Division 7A appear to be a live example of attacking the symptoms of inefficient tax legislation rather than addressing the root cause.
We recognise the need for amendments and enhancement to revenue laws in Australia to enable the positive evolution of our taxation system. However, we also see the broader perspective and the opportunities that could be realised through broad based tax reform in Australia. In our opinion a step change in our taxation system is required, not the mere evolution of that system.
We implore Treasury and our Governments (Federal, State and Local) to continue exploring opportunities to reform Australia’s taxation system. As a nation, we would all share in the benefits arising from altering the taxation mix away from taxes that are more damaging to economic activity (including taxes on income payrolls) to those that have a less negative impact (such as taxes on consumption and land taxes). The challenges in achieving broad based tax reform should not be seen as barriers to implementation and we should take comfort from the positive outcomes achieved in other jurisdictions where meaningful tax reform has been achieved through political will and an engaged electorate.