House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 1 Distributions to entities connected with a private company and related issues

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to remove the automatic debiting of the private company's franking account when a deemed dividend arises under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

1.2 These amendments also provide the Commissioner of Taxation (Commissioner) with a general discretion to disregard the operation of Division 7A where deemed dividends have been triggered by honest mistakes or inadvertent omissions by taxpayers. In addition, other amendments are made to Division 7A to reduce the extent that taxpayers can trigger a deemed dividend inadvertently. The Fringe Benefits Tax Assessment Act 1986 is also amended to exempt Division 7A compliant loans from fringe benefits tax (FBT). Section 108 of the ITAA 1936 is also being repealed.

Context of amendments

1.3 Division 7A is an integrity provision aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In particular, advances, loans and other payments or credits to shareholders or associates are, unless they come within specified exclusions, treated as assessable dividends to the extent that there are realised or unrealised profits in the company.

1.4 When a deemed dividend arises under Division 7A the private company's franking account is debited and the shareholder or associate pays tax on the deemed dividend at their marginal rate of tax.

1.5 These amendments reduce the extent to which taxpayers can trigger a deemed dividend inadvertently. The amendments also reduce compliance costs for taxpayers, especially for small businesses which use a private company structure. Specifically, the amendments will:

•

reduce the double-penalty nature of Division 7A by removing the automatic debiting of the private company's franking account when a deemed dividend arises under the Division. (The nature of the penalty currently applicable is not considered to be in proportion with the tax mischief involved);

•

provide a discretion to the Commissioner to disregard deemed dividends (or allow them to be franked) where they have been triggered by honest mistakes or omissions by taxpayers;

•

provide a discretion to the Commissioner to disregard a deemed dividend where minimum yearly repayments have not been made on a loan because of circumstances beyond the control of the taxpayer;

•

make technical amendments to Division 7A and related areas of the taxation law to provide more flexibility for taxpayers and to reduce the extent to which they can be caught by Division 7A inadvertently;

•

exempt Division 7A compliant loans from FBT; and

•

repeal section 108 of the ITAA 1936.

Summary of new law

1.6 These amendments will remove the automatic debiting of a private company's franking account when a deemed dividend arises under Division 7A of the ITAA 1936. This applies from 1 July 2006.

1.7 Where a deemed dividend arises under Division 7A because of an honest mistake or inadvertent omission by a taxpayer, the Commissioner will have a general discretion to either disregard the deemed dividend subject to conditions being complied with, or allow the private company taken to have paid the dividend, to choose to frank the dividend.

1.8 The Commissioner will be able to use the discretion in relation to the 2001-02 income year and later income years. This will allow the Commissioner to appropriately handle the situation where taxpayers have triggered a deemed dividend inadvertently because of a past mistake or omission.

1.9 In addition, the Commissioner will have a discretion to disregard a deemed dividend where minimum yearly repayments have not been made on a private company loan because of circumstances beyond the control of the recipient of the loan (generally, the shareholder or an associate of the shareholder).

1.10 A range of other amendments will provide more flexibility by reducing the impact of Division 7A on normal business transactions, including allowing the refinancing of some loans and exempting Division 7A compliant loans from FBT.

1.11 Section 108, the predecessor of the Division 7A legislation, is repealed.

1.12 The Commissioner will be given a maximum of three years to make a franking assessment, in cases where an entity is not required to give the Commissioner a franking return for an income year.

Comparison of key features of new law and current law

Detailed explanation of new law

Removal of the automatic debiting of the private company's franking account

1.13 An amendment is being made to item 8 in the table in section 205-30 of the ITAA 1997. This section provides for the debiting of a company's franking account when a deemed dividend arises under Division 7A of the ITAA 1936. The amendment will remove the debiting of the private company's franking account when a deemed dividend arises under Division 7A. [Schedule 1, item 29, section 205-30 of the ITAA 1997]

1.14 Deemed dividends will, however, continue to be included in assessable income as unfranked dividends in the hands of shareholders or their associates. A consequential amendment is also being made to the simplified outline of Division 7A in section 109B of the ITAA 1936 to reflect this change. [Schedule 1, item 1, section 109B of the ITAA 1936]

Allow payments to be converted to loans

1.15 Under the current law, a 'payment' made by a company to a shareholder or an associate of a shareholder can not be treated as a loan unless it is of the kind contemplated by paragraph 109D(3)(c). Paragraph 109D(3)(c) contemplates payments made on account of, on behalf of or at the request of, a shareholder (or their associate) where there is an express or implied obligation to repay the amount to the private company.

1.16 Where paragraph 109D(3)(c) applies the payment is treated as a loan and it must be repaid or put on a commercial footing before the private company's lodgment day in order to escape being treated as a dividend. In all other cases, once the payment is made there is a triggering of section 109C notwithstanding any subsequent desire to repay the amount.

1.17 Under these amendments, a payment not already covered by paragraph 109D(3)(c) may be converted to a loan and the shareholder or associate will have until the lodgment date for the company's tax return to either repay the loan to the company in full, or enter into a written loan agreement with the company meeting the terms of section 109N. Either of these actions will prevent a deemed dividend arising. [Schedule 1, items 2 and 3, note under subsections 109C(3A) and 109D(4) of the ITAA 1936]

Example 1.1

In 2007-08, XYZ Pty Ltd pays the petrol expenses of a vehicle owned by shareholder Sally, who is under no express or implied obligation to repay the amount.

Under the current law a deemed dividend will be taken to arise to Sally under section 109C. Taking into account these amendments, Sally and XYZ Pty Ltd will now have until the lodgment day of XYZ Pty Ltd's tax return (which will be in the 2008-09 income year) to convert the payment into a loan and repay it or enter into a written agreement that satisfies the criteria in section 109N of Division 7A. If the loan is put under a section 109N written agreement, Sally must then make the minimum yearly repayments on the loan in the 2008-09 and following income years by 30 June of each year.

The private company may need to undertake a journal entry in its accounting records to reflect the loan and reverse what may have been recorded as an expense in its financial statements for the 2007-08 income year. If these have been finalised, an adjustment to retained earnings may be required.

Deemed dividend to be the amount of the underpayment

1.18 Under the current law (section 109E), where the amount paid on an amalgamated loan falls short of the minimum yearly repayment, a deemed dividend will arise and the amount of the dividend is taken to be the amount of the amalgamated loan that has not been repaid at the end of the current year of income, subject to section 109Y (ie, there being a distributable surplus at the end of the year of income).

1.19 Taking into account these amendments, a deemed dividend would still arise in the above scenario. However, the amount of the deemed dividend will be the amount of the shortfall in the amount of repayments, not the outstanding balance of the loan. That is, the dividend amount would be the difference between the minimum yearly repayment and the amount paid in the current year. [Schedule 1, items 4, 5 and 9, paragraph 109E(1)(c) and subsection 109E(2) of the ITAA 1936]

1.20 Where minimum yearly repayments have not been made and a deemed dividend arises, the shareholder or the associate will still have the shortfall amount as an outstanding debt with the private company. The shareholder can either make the shortfall payment or ask the company to forgive that amount of the debt. The debt forgiveness of this amount would not trigger a deemed dividend as a result of the new subsections 109G(3A) and (3B). [Schedule 1, items 4, 5 and 9, paragraph 109E(1)(c) and subsection 109E(2) of the ITAA 1936]

1.21 Alternatively, the company could use section 109ZC. A later dividend could be declared and used to offset the deemed dividend (with the agreement of the shareholder). The later dividend will not be included in the shareholder's assessable income to the extent it is unfranked.

1.22 A subsequent change is also made to paragraph (a) in the definition of 'repayments of non-commercial loans' in subsection 109Y(2) of the ITAA 1936 to include any repayments of shortfall amounts previously taken to be dividends under section 109E. [Schedule 1, item 18, subsection 109Y(2) of the ITAA 1936]

Example 1.2

GHI Pty Ltd has made a $100,000 loan to one of its shareholders, Ben. The minimum yearly repayment on the loan is $20,000 reflecting principal of $13,000 and interest of $7,000. Ben, however, only manages to repay $19,000 during the first income year after the loan was made. Under the current law, a deemed dividend would therefore arise equal to the outstanding balance of the loan, which is $88,000. Taking these amendments into account, a deemed dividend would still arise, but the amount will be the amount of the underpayment, which is $1,000 (ie, $20,000 less $19,000).

1.23 Because of these changes, a subsequent amendment is also made to subsection 109G(3) to prevent double taxation when a loan or shortfall amount is subsequently forgiven. If the company forgives the debt, the amount of the deemed dividend that arises because of the debt forgiveness will be reduced by the amount of any shortfalls previously treated as dividends in relation to the loan. [Schedule 1, items 7 and 9, subsections 109G(3A) and (3B) of the ITAA 1936]

Example 1.3

Following Example 1.2, GHI Pty Ltd decides to forgive the outstanding loan in the next income year. Because of the amendment, the amount of the deemed dividend will be only $87,000 (ie, the amount of the actual debt being forgiven, which is $88,000 less the shortfall amount previously treated as a deemed dividend, being $1,000).

Allow refinancing of loans

1.24 Loans that meet the minimum interest rate and maximum term criteria under section 109N do not trigger a deemed dividend. One of the criteria is the maximum term of a loan, which is 25 years if:

•

100 per cent of the value of the loan is secured by a mortgage over real property that has been registered in accordance with a law of a state or territory; and

•

when the loan is first made, the market value of that real property ( less the amounts of any other liabilities secured over that property in priority to the loan) is at least 110 per cent of the amount of the loan.

For loans not secured by a mortgage over real property, the maximum term is seven years.

1.25 Subsection 109R(2) provides that a payment must not be taken into account (in regard to determining whether a loan has been repaid in whole or in part in the year in which it was made, or in determining whether a minimum yearly payment has been made) if a reasonable person would conclude (having regard to all the circumstances) that when the payment was made the entity intended to obtain a loan from the private company of an amount similar to or larger than the payment. This provision prevents loans from being continually refinanced, effectively never being repaid and thus avoiding the operation of Division 7A.

1.26 If payments are disregarded, a deemed dividend arises. These amendments will allow some genuine refinancing of loans between a company and a shareholder or an associate of a shareholder without the potential for a deemed dividend to arise.

1.27 Subsection 109R(5) is inserted so that a loan can be refinanced without triggering a deemed dividend under subsection 109R(2) when a private company loan becomes subordinated to another loan from another entity (such as a bank), and the refinancing of the private company loan by the shareholder or associate takes place because of that subordination. The subordination must have arisen because of circumstances beyond the control of the shareholder/associate, and the parties that made the loans must be dealing with each other on an arm's length basis. [Schedule 1, item 12, subsection 109R(5) of the ITAA 1936]

Example 1.4

JKL Pty Ltd has made a loan of $10,000 to a shareholder, Steve. The loan meets the minimum requirements stipulated by section 109N and Steve is making the minimum yearly repayments. Steve also has a loan of $50,000 from MNO Bank, which he defaults on. As a result, MNO Bank requires the loan from JKL Pty Ltd to be subordinated to the loan from MNO Bank. Because of the subordination, the shareholder must make the required payments on the loan with the bank before any repayments can be made on the loan with the private company. Under this amendment, Steve could refinance the loan with the private company to, for example, extend the term and reduce the minimum yearly repayments.

1.28 Section 109N is amended and subsections 109R(6) and (7) are inserted to allow loans to be refinanced in certain circumstances without a deemed dividend being triggered.

1.29 An unsecured loan can be converted to a loan secured by a mortgage over real property with a longer maximum term. The maximum term of such a loan is 25 years, less the period of the term already expired in the old loan. Division 7A operates with the concept of an amalgamated loan (which could comprise of one or more constituent loans with the private company). When the term of an existing loan is simply extended because of a mortgage, a new amalgamated loan is taken to be made in the income year prior to the income year in which the extension takes place. [Schedule 1, items 6, 10 and 12, subsections 109E(3A) and (3B), 109N(3A) and (3B) and 109R(6) of the ITAA 1936]

Example 1.5

DEF Pty Ltd makes an unsecured loan of $10,000 to one of its shareholders, Greg. The term of the loan is seven years. After three years, the old loan is refinanced (ie, the old loan is repaid and a new loan secured by a mortgage over real property is created with the private company). In the written agreement governing the new loan, the maximum term will be 22 years (25 years less 3 years).

Example 1.6

Using the same details as per Example 1.5, DEF Pty Ltd simply agrees to extend the term of the existing loan and a new written agreement is made. The extended maximum term will still be 22 years. For Division 7A purposes the new subsection 109E(3B) treats the varied loan as a new amalgamated loan having been made just before the start of the income year in which the loan term is extended. Therefore, minimum yearly repayments will still be required in that income year calculated in accordance with section 109E.

1.30 A loan secured by a mortgage over real property can be refinanced with an unsecured loan. The maximum term of the new loan can be seven years if the actual term of the old loan to date was less than 18 years. If the secured loan has already been in place for more than 18 years, the maximum term of the new unsecured loan will be reduced so that the total term of the loan (in both its secured and unsecured form) will be no more than 25 years. If the actual term of the old loan up until the time the loan is refinanced exceeds 18 years, the maximum term of the new loan is seven years reduced by the number of years in excess of 18 years. [Schedule 1, items 10 and 12, subsections 109N(3C) and (3D) and 109R(7) of the ITAA 1936]

Example 1.7

Hilda Pty Ltd has made a loan secured by a mortgage over real property to an associate of a shareholder, Sachin. The term of the loan was 25 years. However, after 20 years, the terms of the loan are changed and it is no longer secured by a mortgage over real property. If the expired term of the old secured loan was less than 18 years, the maximum term of the new loan will be seven years. However, in this particular instance, the original secured loan had already been in place for more than 18 years. As a result, in the written agreement governing the new loan, the maximum term of the loan can be five years,

(ie, 7 years - (20 years - 18 years) = 5 years).


The Commissioner's power to disregard the operation of Division 7A or allow a dividend to be frankable

1.31 New section 109RB allows the Commissioner to either disregard a deemed dividend that arises under Division 7A or allow a private company to choose to frank a deemed dividend that it has been taken to pay. [Schedule 1, item 13, section 109RB of the ITAA 1936]

1.32 The provision requires a two stage process. The Commissioner can only act if the failure to satisfy the requirements of Division 7A is the result of an honest mistake or inadvertent omission by any of the following:

•

the recipient (the shareholder or an associate of the shareholder);

•

the private company that makes the payment or loan or that is taken to pay the dividend under Division 7A; or

•

any other entity whose conduct contributed to the deemed dividend arising under Division 7A (this could include, for example, an interposed company or trust that makes a payment or loan to a shareholder or an associate of the shareholder of the private company).

[Schedule 1, item 13, paragraph 109RB(1)(b) of the ITAA 1936]

1.33 Whether or not there is an honest mistake or inadvertent omission is an objective question to be determined by reference to all the circumstances surrounding the failure to satisfy the requirements of Division 7A. In practice, the taxpayer will need to demonstrate to the Commissioner that the failure was the result of an honest mistake or inadvertent omission. [Schedule 1, item 13, paragraph 109RB(1)(b) of the ITAA 1936]

1.34 Once it is established that there is an 'honest mistake or inadvertent omission', the Commissioner is then empowered to make a decision. In considering whether to exercise his power in favour of a taxpayer, the Commissioner must have regard to the following:

•

the circumstances that led to the mistake or omission which caused the deemed dividend to arise;

•

the extent to which the relevant taxpayer(s) had acted to try to correct the mistake or omission, and if so how quickly that action was taken after the mistake or omission was identified;

•

whether Division 7A had operated previously in respect of the relevant taxpayers, and if so, the circumstances in which this occurred, for example, if the Commissioner had previously exercised his power under this provision in relation to the entity that made the mistake or omission; and

•

any other matters that the Commissioner considers relevant, for example, the quantum of sums involved.

1.35 However, in making that decision the Commissioner must consider all of the relevant factors in the context of the particular circumstances of each individual taxpayer. The respective weighting of each factor depends on the actual circumstances of the case. The shareholder or the private company or both may apply to the Commissioner to exercise his power to disregard a deemed dividend. Alternatively, the Commissioner may make a decision under this provision without being asked to do so by the company or shareholder. [Schedule 1, item 13, subsection 109RB(3) of the ITAA 1936]

1.36 An examination of the circumstances that led to a mistake or omission provides an opportunity to consider both the nature and extent of the mistake or omission. There is a very wide range of possible mistakes or omissions that would result in Division 7A deeming there to be a dividend paid to a taxpayer. For example, there may be a complete failure to make any minimum yearly repayment over a long period of time, or there may be a simple miscalculation of the minimum yearly repayment in one year. Likewise, there is a wide spectrum of circumstances in which there might be a failure to satisfy the requirement for a written loan agreement under section 109N. For example, there may be no agreement of any kind, or there may be a written agreement that satisfies all the requirements of the provision other than for an interest rate slightly lower than that required by the law.

1.37 No action by a taxpayer can alter the operation of Division 7A once that Division has deemed a dividend to have been paid to a taxpayer; it is only the Commissioner who can act to undo the deeming. However, a taxpayer can act to correct the mistake or omission that resulted in the deemed dividend. For example, if the relevant mistake was a failure to enter into a written loan agreement, then the company and its shareholder could enter into a loan agreement that satisfies the requirements of section 109N. By way of another example, if the relevant mistake was a failure to pay the full amount of the minimum yearly repayment then the shareholder could repay the outstanding amount, and ensure that the correct amount is repaid in the future.

1.38 The Commissioner may make a decision subject to specified conditions. This will allow the Commissioner to require that the mistake or omission that gave rise to the failure to satisfy Division 7A be corrected within a specified time period. For example, the Commissioner could require that:

•

loan documentation be put in place that meets the criteria in section 109N; and/or

•

if the minimum yearly repayments have not been made by the due date, that the minimum amounts be paid by a later specified date.

[Schedule 1, item 13, subsection 109RB(4) of the ITAA 1936]

1.39 If the conditions are not met then the deemed dividend will not have been disregarded. [Schedule 1, item 13, subsection 109RB(5) of the ITAA 1936]

1.40 If a deemed dividend is disregarded because the Commissioner makes a decision under section 109RB, then had there previously been a debit to the private company's franking account because of the deemed dividend, the private company's franking account can be re-credited by the amount of the debit.

1.41 The Commissioner may make a decision that the private company can choose to frank the deemed dividend in accordance with Part 3-6 of the ITAA 1997. If the private company does frank the dividend, the private company's franking account will be debited as per item 1 in the table in section 205-30 of the ITAA 1997. [Schedule 1, items 13 and 28, subsection 109RB(6) of the ITAA 1936 and subparagraph 202-45(g)(i) of the ITAA 1997]

1.42 The Commissioner's discretion to allow dividends to be franked would apply only where the dividend is made to a shareholder, not to an associate of the shareholder. The Commissioner will not be able to make a decision to permit the franking of a deemed dividend that arose before the 1 July 2002, the commencement of the simplified imputation system. [Schedule 1, subitem 43(4 )]

1.43 Amounts included as if they were dividends in the assessable income of a particular entity under Subdivision 7A-EA are not frankable as the private company is not taken to pay the dividend in these circumstances.

Example 1.8

A private company makes a loan to a shareholder in the 2007-08 income year for $100,000. In making the loan, a written agreement is prepared and the term of the loan is seven years.

However, after the return for the 2008-09 income tax year has been lodged the shareholder discovers that the company had made a mistake and advised the shareholder of the wrong interest rate when calculating the minimum yearly repayment. The shareholder only made minimum repayments of $19,000 in 2008-09 instead of the required $20,000. A deemed dividend has arisen as the repayments were lower than required. Once the shareholder realised the payments were lower than required he corrected that mistake by paying an additional $1,000 in the 2009-10 income year to catch-up on the lower payments. The shareholder also immediately advised the Commissioner that lower repayments had been made and that they would like the Commissioner to exercise the discretion.

In order for the Commissioner to exercise his power under this provision it must be established that the failure to pay the minimum yearly repayment was the result of an honest mistake or inadvertent omission. In determining whether there was such a mistake or omission, evidence of the company and shareholder's attempt to comply with the requirements of Division 7A (eg, by making yearly repayments in respect of the loan) would be relevant, as would evidence as to why the wrong interest rate was used in the calculation of the minimum yearly repayment amount.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

that there was a loan agreement in place between the company and the shareholder that satisfied all of the requirements of section 109N;

•

the use of the wrong interest rate to calculate the minimum yearly repayment resulted in a relatively small underpayment;

•

once the shareholder discovered the mistake, the taxpayer took action to promptly advise the Commissioner of the mistake; and

•

the shareholder took steps to correct the mistake and to discharge their legal obligation under the loan agreement to make a minimum yearly repayment of $20,000.

Example 1.9

In the 2007-08 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the income year. The company and shareholder both state that they thought loan documentation was not necessary provided the interest charged was commercial in nature.

Since there was no loan agreement and the minimum yearly repayments made in 2006-07 were less than would be required to meet the terms of section 109E, a dividend was deemed to have been paid to the relevant shareholder.

In order for the Commissioner to exercise his power under this provision it must be established that the failure to enter into a loan agreement that satisfies the requirement of section 109N, and the failure to pay the minimum yearly repayment was the result of an honest mistake or inadvertent omission. Again, evidence of the shareholder attempting to comply with the intent of Division 7A (eg, by making yearly repayments in respect of the loan) would be relevant when determining if there had been an honest mistake or omission.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the nature of the two mistakes;

•

the level of interest actually charged by the company on the loan;

•

the actual making of yearly repayments on the loan for each year since the loan was entered into; and

•

whether Division 7A has operated previously in respect of either the private company or the shareholder.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement that satisfied all of the requirements of section 109N and for the shareholder to make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the shareholder had satisfied the requirements of section 109E.

Example 1.10

A business consists of a private company (ABC Pty Ltd) and XYZ trust. Both entities are controlled by Sam and Mel. The trust's beneficiaries are Sam and Mel and they are also shareholders of the company. The trust owns land and buildings which are mortgaged to a financial institution. The company has a loan with a different financial institution. The interest on both loans is tax deductible as the loans are used for income generating purposes.

In the 2005-06 income year the company and the trustee of the XYZ trust decide to consolidate their debts. The company extends its pre-existing loan facility and pays out the loan that the trust has with its bank.

Since the trust estate is an associate of the shareholders of ABC Pty Ltd, Division 7A will deem a dividend to be paid by the private company to the trustee of the XYZ trust as a deemed shareholder in ABC Pty Ltd. Upon discovering the situation the trustee applied to the Commissioner to exercise his power to disregard the deemed dividend as soon as it became aware that Division 7A deemed a dividend to have been paid.

In order for the Commissioner to exercise his powers under this provision either the company or the trustee will need to establish that the relevant officers and employees of the private company and the trustee made an honest mistake as to the operation of Division 7A to the debt consolidation.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the circumstances surrounding the mistake or omission, including the amount of the deemed dividend;

•

the commercial nature of the transaction between the company and the trust; and

•

that once the taxpayers discovered the problem they brought the matter to the Commissioner's attention.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement that satisfied all of the requirements of section 109N be entered into between the company and the trustee and for the trustee to make catch-up minimum yearly repayments.

Example 1.11

Fred and Jen operated a number of separate businesses through different entities including a private company and a trust. They were the trustees of the trust and the only shareholders and directors of the private company. The beneficiaries of the trust are Fred and Jen and members of their immediate family.

During the 2005-06 income year the trust was incurring substantial losses due to a downturn in business conditions. As no other source of funds were available the private company made loans to the trust for working capital purposes during the year.

There were no qualifying section 109N written agreements put in place before the lodgment day of the private company's 2005-06 tax return and no loan repayments had been made to the private company. However, the loan is recognised in the balance sheets of the private company and the trust and the loan is minuted along with a note that the trust is envisaged to resume profitability by the 2008-09 year at which time loan repayments will commence. Division 7A had not operated previously in relation to the private company or the trustee.

In preparing the 2005-06 income tax returns Fred and Jen considered the application of Division 7A but mistakenly believed that only loans to individual shareholders would be subject to Division 7A. Fred and Jen sought tax advice during the 2006-07 income year and the Division 7A problem in the 2005-06 year was immediately brought to their attention. Fred and Jen promptly advised the Commissioner of the mistake.

In considering whether to exercise his power in favour of the trust, the Commissioner would have regard to the following:

•

the fact that the mistake was the result of a misreading of the legal requirements of Division 7A;

•

the relatively short period of time that has elapsed between the year in which the dividend was deemed to be paid and the notification to the Commissioner;

•

the relatively short period of time that has elapsed between when the mistake was identified and the notification to the Commissioner;

•

whether there was any reasonable prospect that the trust would be able to repay the loan, and if so when;

•

the disclosure of the transaction as a loan in the balance sheets of the private company and trust;

•

the quantum of the sums involved; and

•

that Division 7A had not operated previously in relation to the private company or the trustee.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and that the trustee make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the trustee had satisfied the requirements of section 109E.

Example 1.12

In the 2007-08 income year, the Commissioner undertakes an audit of EFG Pty Ltd. In the course of the audit, the Commissioner discovers that an interest-free at call loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan and no repayments have been made. Nor was the loan disclosed in the company's books of account. In addition, the loan was made out of income that was not disclosed in the tax return of EFG Pty Ltd for the 2005-06 income year.

On the basis of the objective evidence, the taxpayer has failed to establish that the deemed dividend was the result of an 'honest mistake or inadvertent omission'. Rather it appears that the company has deliberately ignored the operation of Division 7A and has simply sought to distribute undisclosed profits to a shareholder. In such a situation the prerequisite for the Commissioner to exercise his power in subsection 109RB(2) has not been satisfied.

Example 1.13

In the 2007-08 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a trust that is an associate of a shareholder of the private company in the 2005-06 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the income year. The directors of the company and the trustee believed that loan documentation was not necessary provided the interest charged was commercial in nature.

As there was no loan agreement which met the requirements of section 109N put in place by the required time a deemed dividend is taken to have arisen in the year the loan was made. The amount of the deemed dividend is the balance of the loan outstanding just before the company's lodgment day for the income year.

If there has been an honest mistake or inadvertent omission then, in considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the level of interest charged by the company on the loan; and

•

whether either the private company or the trust had enforcement action undertaken by the Commissioner in respect of any other deemed dividends in the current or earlier years.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and that the trustee make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the trustee had satisfied the requirements of section 109E.

Franking deemed dividends because of a marriage or relationship breakdown

1.44 Under the current law, transfers of property and other 'payments' in respect of marriage or relationship breakdown are caught by Division 7A even though they may be non-voluntary (eg, due to a court order). As such a deemed dividend may arise.

1.45 The amendment provides that deemed dividends arising from 'payments' in respect of marriage or relationship breakdown, may be frankable by the private company taken to pay the deemed dividend. The dividend may be franked irrespective of whether it was made to a shareholder or associate of the shareholder (eg, an ex-spouse). [Schedule 1, items 13 and 28, section 109RC of the ITAA 1936 and subparagraph 202-45(g)(i) of the ITAA 1997]

1.46 The private company may frank the dividend in accordance with Part 3-6 of the ITAA 1997, subject to the dividend being franked at the private company's benchmark franking percentage for the period in which the dividend is taken to be paid, or if no franking percentage exists, at 100 per cent. [Schedule 1, item 13, subsection 109RC(3) of the ITAA 1936]

1.47 If the private company franks the dividend, the private company's franking account will be debited (as per item 1 in the table in section 205-30 of the ITAA 1997).

1.48 The dividend may only be franked in the same circumstances that CGT roll-over relief applies in relation to relationship breakdowns.

1.49 Examples of where deemed dividends (arising because of a 'family law obligation') may be franked under the new law can be found in subsection 126-5(1) of the ITAA 1997. They include (but are not restricted to):

•

a court order under the Family Law Act 1975 or a corresponding foreign law;

•

a maintenance agreement approved by a court under section 87 of that Act or a corresponding agreement approved by a court under a corresponding foreign law; or

•

a court order under state law, territory law or foreign law relating to de facto marriage breakdowns.

[Schedule 1, item 23, definition of 'family law obligation' in section 109ZD of the ITAA 1936]

Example 1.14

Jack and Stephanie divorce. Stephanie owns and controls private company BCD Pty Ltd. The Family Court orders Stephanie to transfer the private company's motor vehicle to Jack as part of the property settlement. This transaction will trigger a deemed dividend under Division 7A. The amendments will allow the dividend to be franked like other dividends that the private company declares in the income year that it transfers the motor vehicle to Jack.

Discretion for the Commissioner to disregard a deemed dividend and extend the time for making minimum yearly repayments.

1.50 New section 109RD provides the Commissioner with a discretion to disregard a deemed dividend where the recipient of a private company loan (ie, the shareholder or an associate of the shareholder) was unable to make the minimum yearly repayments because of circumstances beyond their control. The Commissioner can specify a later time by which the minimum yearly repayments must be made. [Schedule 1, item 13, section 109RD of the ITAA 1936]

1.51 Circumstances that may be outside the control of the recipient of a private company loan could include:

•

the shareholder has been in an accident and hospitalised and can not make the minimum yearly repayments;

•

the shareholder has been hospitalised because of an illness and can not make the minimum yearly repayments;

•

the shareholder is prevented from making the minimum yearly repayments because their assets have been frozen by a court; or

•

the shareholder may have another loan with a third party, for example a bank, and through a subordination of the private company loan, the shareholder is prevented from making any payments on the private company loan.

1.52 This provision does not need to consider whether the recipient will suffer undue hardship as these circumstances are already covered by the Commissioner's existing discretion in section 109Q.

Example 1.15

XYZ Pty Ltd provides its shareholder Bill with a secured loan. Bill also has a loan with ABC bank which was taken out before the private company loan. Because of events outside Bill's control, he defaults on the bank loan and as a result the bank requires Bill's loan with the private company to be subordinated to its loan. As a result of this subordination, the bank prevents Bill from making any repayments on the private company until the bank's loan is brought up to date. By not making the required minimum yearly repayments, a deemed dividend will arise in the relevant income year.

Bill may apply to the Commissioner to exercise his discretion to disregard the deemed dividend and extend the time in which to make the minimum yearly repayments. If the Commissioner is satisfied that the circumstances that led to Bill not being able to make the minimum yearly repayments were beyond his control, he may exercise his discretion to disregard the deemed dividend and extend the time for making the repayments. Bill would need to continue to apply to the Commissioner in each subsequent year if the problem persisted.

Loan guarantees

1.53 Under the current law, where a private company guarantees a loan made by a third party to a shareholder and the private company is required to make a payment to the third party because the shareholder defaults on the loan, the payment is treated as a deemed dividend from the private company to the shareholder. Furthermore, the loan that arises between the company and the shareholder is also a loan (a common law debt) to which Division 7A applies.

1.54 The amendment to section 109UA exempts guaranteed loans where the shareholder (or associate) enters into a loan agreement with the private company and that loan meets the requirements of section 109N. Neither the loan guarantee liability that arises when the guarantor pays on the defaulting loan, nor the common law debt that arises between the private company and the shareholder (or their associate) will trigger a deemed dividend in these circumstances. [Schedule 1, item 14, subsection 109UA(5 )]

Example 1.16

ABC Bank Pty Ltd has made a loan to Mary, who is a shareholder of XYZ Pty Ltd, which guarantees Mary's bank loan. However, Mary defaults on the bank loan and XYZ Pty Ltd becomes liable to make a payment to the bank. This liability, which is not a contingent liability, will cause a deemed dividend to arise, unless XYZ Pty Ltd and Mary enter into a loan agreement (in respect of the common law debt) that meets the minimum interest rate and maximum term criteria in section 109N and minimum yearly repayments are made in subsequent income years.

Loans involving interposed entities

1.55 The current law does not allow a loan made by an interposed entity to a shareholder of a private company to be an excluded loan under section 109N or for any repayments of such a loan to be repayments for the purposes of section 109E. The amendment to subsection 109X(2) and new subsections 109X(3) and (4) have the effect of allowing:

•

a loan agreement between the interposed entity and the shareholder or associate (that meets the criteria of section 109N) to be treated as a loan between the private company and the shareholder or associate for Division 7A purposes; and

•

repayments made by the shareholder or associate against the actual loan with the interposed entity to be taken to be repayments of the notional loan between the private company and the shareholder or associate. Repayments are determined having regard to the amount of the notional loan worked out under subsection 109W(3) of the ITAA 1936.

[Schedule 1, item 15, subsection 109X(4 )]

Example 1.17

DEF Pty Ltd makes a payment to ABC Pty Ltd. Under an arrangement with DEF Pty Ltd, ABC Pty Ltd on loans that amount to one of DEF Pty Ltd's shareholders, that is, Julie. A loan agreement is in place between ABC Pty Ltd and Julie that meets the criteria in section 109N. Under the current law, a deemed dividend would arise under this arrangement as DEF Pty Ltd would have been taken to pay a dividend to Julie (subject to an available distributable surplus). However, the amendments to subsection 109X(2) and new subsections 109X(3) and (4) will treat the loan agreement between ABC Pty Ltd and Julie as the relevant agreement for the purpose of section 109N and a deemed dividend will not arise so long as minimum yearly repayments are made in accordance with section 109E in subsequent income years (item 15 and subsections 109X(2) to (4)).

Calculation of distributable surplus

1.56 Section 109Y of the ITAA 1936 provides a formula for calculating whether the private company has a distributable surplus in the income year that a deemed dividend arises. If a private company has no distributable surplus, then the amount of a deemed dividend will be nil. The amount of the deemed dividend can not exceed the private company's distributable surplus.

1.57 Under subsection 109Y(2), if the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, he may substitute a value that he considers is appropriate. The amendments extend this power so that the Commissioner may also substitute values if he considers that the company's accounting records significantly overvalue its assets or undervalue its provisions. [Schedule 1, items 16 and 17, subsection 109Y(2) of the ITAA 1936]

Payment of an offset dividend not taxable when a deemed dividend arises - technical correction to section 109ZC

1.58 Under the current law, section 109ZC of the ITAA 1936 is designed to prevent double taxation where a later dividend distributed by a private company is offset against an amount already treated as a dividend paid by the company. The later dividend set off (to the extent that it is unfranked) is not assessable income up to the amount of the deemed dividend. However, there is a concern that double taxation may arise if the borrower is not the shareholder of the company, but an associate. These amendments will allow later distributions of dividends to be applied by a shareholder to offset amounts of deemed dividends previously taken to be paid to an associate of a shareholder, but only to the extent of the amount of the deemed dividend previously taken to be paid. [Schedule 1, items 19 and 20, subsection 109ZC(2) of the ITAA 1936]

Example: 1.18

ABC Pty Ltd makes a loan to Mel, who is an associate of one of its shareholders, Ben. Ben has an arrangement with ABC Pty Ltd that any dividends declared are to be put towards repaying the loan that Mel has with ABC Pty Ltd. Mel also makes payments. Mel has defaulted on the loan and a deemed dividend has arisen under Division 7A.

ABC Pty Ltd declares a dividend to shareholders. Under Ben's arrangement with ABC Pty Ltd the full amount of his dividend is applied to reduce the amount of Mel's loan, partially offsetting the amount of the deemed dividend that was previously taken to have been paid to Mel. This later dividend, up to the amount of the deemed dividend previously taken to be paid, will not be treated as assessable income to the extent that it is unfranked.

Division 7A - excluded loans / FBT interactions

1.59 The FBT amendment directly removes the FBT consequences of making a loan to a shareholder who is also an employee, where the loan meets the excluded loan requirements in section 109N of the ITAA 1936. These amendments reduce compliance costs for taxpayers with these types of loan arrangements, because they do not need to consider the application of FBT to the loans. The minimum interest rate requirements in Division 7A provide sufficient integrity around the making of loans by private companies to shareholders.

1.60 These amendments exclude loans that would give rise to deemed dividends, were it not for section 109N of the ITAA 1936, from the definition of 'fringe benefit' in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 . Basically, this means that any loan that meets the conditions in section 109N of the ITAA 1936 will not be a fringe benefit.

1.61 In the year that a loan is made, two groups of loans are excluded from the definition of 'fringe benefit':

•

loans that give rise to deemed dividends under section 109D of the ITAA 1936 (because of existing paragraph (r) of the definition of 'fringe benefit' in the Fringe Benefits Tax Assessment Act 1986 which excludes anything that gives rise to a deemed dividend under Division 7A); and

•

loans that would give rise to deemed dividends under section 109D, were it not for meeting the requirements of section 109N.

[Schedule 1, items 30 to 32, subsection 136(1), paragraph (s) of the definition of 'fringe benefit' of the Fringe Benefits Tax Assessment Act 1986]

Example 1.19

Zoe, a shareholder and employee of Small Company Pty Ltd, is provided with a loan by Small Company Pty Ltd on 1 August 2007. The loan documents for the loan are finalised on 1 March 2008, and meet the excluded loan requirements in section 109N of Division 7A. No repayments (including interest) are payable on the loan until 1 July 2008.

Loan benefits may arise in the 2007-08 and the 2008-09 FBT years because no interest is paid. However, as the loan meets the requirements to be an excluded loan under section 109N, the loan is not a fringe benefit. The fact that Zoe does not pay interest does not result in an FBT liability for Small Company Pty Ltd.

1.62 In subsequent years, loans that form part of an amalgamated loan under section 109E are not subject to FBT. This is because, under existing paragraph 109E(3)(b), for a loan to be a part of an amalgamated loan under section 109E, the loan must be a loan to which section 109D would have applied, were it not for section 109N. This means that it will be excluded from the definition of 'fringe benefit' under the new provision. [Schedule 1, items 30 to 32, definition of 'fringe benefit' in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 and the note in subsection 16(1 )]

Example 1.20

Following from Example 1.19, on 1 July 2008, the loan to Zoe is subject to interest at a rate of 7 per cent for that income year. The benchmark interest rate (for Division 7A) and the statutory interest rate (for FBT) are both 7 per cent at that time. On 1 April 2009, the FBT rate is set to 8 per cent.

For the period 1 April 2009 to 30 June 2009, Zoe is paying less than the rate of interest required to avoid the loan having a taxable value for FBT. However, the loan is not a fringe benefit, because it is a loan that did not give rise to a deemed dividend under Division 7A, but would have done were it not for section 109N.

1.63 In subsequent years, loans that form part of an amalgamated loan will not be subject to FBT, even if the Commissioner exercises the discretion in section 109Q or 109RD to not deem a dividend to have been paid if the amount paid in relation to the loan is less than the minimum yearly repayment required.

1.64 In addition, loans made by trustees that would have given rise to a deemed dividend under section 109XB had they been made by a private company, were it not for section 109N, are not fringe benefits.

Repeal of section 108 from the ITAA 1936

1.65 Section 108 is being repealed. Section 108 is the predecessor of Division 7A and provides that if a private company makes a payment or loan to a shareholder or associate then the amount may be deemed to be a dividend. Unlike Division 7A, it is not self-executing. After nearly 10 years of the operation of Division 7A and in light of the limited amendment periods for the Ausralian Taxation Office (ATO) to adjust income tax returns, section 108 is no longer considered necessary. The effect will be to remove the uncertainty for taxpayers which has been created by having two sets of similar provisions applying to essentially the same set of transactions. [Schedule 1, item 33]

1.66 Section 108 dividends that have arisen in prior years are taken into account in determining whether the private company has a distributable surplus under section 109Y, if the actual loan that triggered the dividend is in the accounts of the company. Consquently, the references to section 108 (or subsections) in the definitions of 'non-commercial loans' and 'repayments of non-commercial loans' are amended to refer to 'former section 108' or 'former subsection 108(2)'. [Schedule 1, items 34 to 36, subsection 109Y(2) of the ITAA 1936]

Time limit for making franking assessments (Schedule 1, Part 3)

1.67 An amendment is made to section 214-60 of the ITAA 1997 to provide the Commissioner with a maximum period of three years to make a franking assessment, in cases where an entity is not required to give the Commissioner a franking return for an income year.

1.68 Generally, the Commissioner will have three years from the later of:

•

the time the entity was required to lodge an income tax return for the income year; and

•

the time when the entity lodged the income tax return for the year of income.

[Schedule 1, item 42, subsection 214-60(1A) of the ITAA 1997]

Application and transitional provisions

1.69 Subject to the following variations, the amendments made by Schedule 1 apply to assessments for the income year in which 1 July 2006 occurred, and later income years. [Schedule 1, subitem 43(1 )]

1.70 The FBT amendment applies to benefits provided in a year of tax that begins on or after 1 April 2007. [Schedule 1, subitem 43(2 )]

1.71 The FBT amendment also applies to all relevant loans from 1 April 2007, if the loan was made prior to this date. This is because, irrespective of whether or not the loan was made before or after 1 April 2007, for the loan to be part of an amalgamated loan under Division 7A, it must have been a loan that did not give rise to a deemed dividend under Division 7A, but would have done were it not for section 109N. This operation is clarified in the application provision. [Schedule 1, subitem 43(3 )]

1.72 To the extent that the amendments relate to section 109RB of the ITAA 1936 (the Commissioner's discretion to either disregard the deemed dividend or allow the private company to frank the dividend), they apply in relation to the 2001-02 income year and later years. [Schedule 1, subitem 43(4 )]

1.73 The Commissioner cannot make a decision to allow a dividend to be franked if the dividend was paid before 1 July 2002, as this period is before the commencement date of the simplified imputation system. [Schedule 1, subitem 43(4 )]

1.74 Where the Commissioner exercises his discretion under section 109RB to disregard a deemed dividend from an earlier year of income, he will be able to amend the private company's franking assessment accordingly. [Schedule 1, subitem 43(4 )]

1.75 The amendments made by Part 3 of this Schedule ( Time limit for making franking assessments ), applies to franking assessments for the income year in which 1 July 2006 occurred and later income years. [Schedule 1, item 42, subitems 43(4) and (6), subsection 214-60(1A) of the ITAA 1997]

1.76 Section 170 of the ITAA 1936 does not prevent an amendment of an assessment if the assessment was made before the commencement of section 109RB (the Commissioner's discretion) if it is made within four years after commencement of section 109RB and the amendment is made for the purpose of giving effect to a decision of the Commissioner under section 109RB of the ITAA 1936. [Schedule 1, subitem 43(5 )]

Consequential amendments

1.77 Because section 108 of the ITAA 1936 is repealed, there are a number of references to section 108 (or subsection 108(2)) that are either being omitted or the reference is amended to refer to 'former section 108' or 'former subsection 108(2)' where appropriate. [Schedule 1, items 8, 34 and 35, subsection 109Y(2), paragraphs 109G(3)(b), 160AEA(1)(d) and 268-40(5)(b) in Schedule 2F to the ITAA 1936 and paragraph 165-60(5)(b), subparagraph 202-45(g)(ii) and section 10-5 of the ITAA 1997]

REGULATION IMPACT STATEMENT

Policy objective

1.78 The purpose of Division 7A of the ITAA 1936 is to prevent private companies ^[1] from making tax-free distributions of profits to shareholders (or their associates) in the form of a payment, loan or forgiven debt. Unless they come within specified exclusions ^[2] , advances, loans and other credits by private companies to shareholders (or their associates) are treated as assessable dividends to the extent that there are realised or unrealised profits in the company.

1.79 The objective of reviewing the Division 7A provisions was to reduce both the extent to which taxpayers are inadvertently caught by Division 7A and the unduly punitive nature of the provisions. The tax impost resulting from a breach of Division 7A is considered to be out of proportion with the tax mischief involved.

Background

1.80 Division 7A is a self-executing provision that requires taxpayers - the private company and its shareholders and their associates - to be fully aware of all its consequences. Taxpayers must self assess if they are caught by the provisions. If a private company makes a payment or loan to a shareholder (even inadvertently) which is not put on a proper commercial footing, generally by the time the company lodges its tax return, then the private company's franking account is debited and the deemed dividend is taxable in the hands of the shareholder; but without entitlement to an imputation credit to offset the tax paid by the company.

1.81 Advice from both the accounting profession and the ATO indicates that in practice the application of Division 7A is widely misunderstood by taxpayers resulting in inadvertent and frequent breaches of the provisions. It has been described by some tax practitioners as the most commonly encountered problem area for practitioners outside the big four accounting firms. The ATO has identified in its Compliance Program 2005-06 that shareholder loan arrangements are a concern and that the ATO needs to lift awareness of the rules among businesses and their tax agents, to increase compliance with Division 7A.

1.82 Division 7A was introduced with effect from 4 December 1997 because section 108 of the ITAA 1936, which also deemed certain amounts to be dividends, only applied when the Commissioner formed the opinion that an amount loaned, paid or credited represented a distribution of profits. Such opinions could not generally be formed without information which was usually only available after conducting an audit. Division 7A, on the other hand, is intended to operate automatically through self-assessment.

Implementation options

1.83 There are essentially two options to deal with this issue.

Option 1

1.84 Option one would be for the Government to remove the self assessment nature of Division 7A and rely solely on the ATO to identify breaches through audit activity.

1.85 This was not considered feasible for a number of reasons:

•

it would revert to a system that was in place prior to 4 December 1997 that relied on the Commissioner identifying specific tax-avoidance activity. This involved the Commissioner forming an opinion that the amount loaned, paid or otherwise credited, represented a distribution of profits. In order to be in a position to form this opinion, the Commissioner needed to consider many factors and analyse much information, which usually was not available unless the Commissioner conducted an audit. Consequently, many loans which should have been taxable as dividends were not taxed. Against this background, the Government specifically moved away from this system. It is also inconsistent with Government policy on self assessment and the need to provide more certainty for taxpayers. Under the current regime taxpayers self assess other taxes such as the goods and services tax (GST) and the FBT, etc; and

•

taxpayers may be encouraged to avoid tax as the risk of detection through ATO audit activity may be perceived to be small. At present, many private companies use tax agents who are expected to be aware of the requirements of the tax law and who can advise their clients on various aspects of their tax affairs, including Division 7A requirements.

On this basis this option was not assessed further.

Option 2

1.86 The second and preferred option was to make the following changes to provide more flexibility and certainty to taxpayers:

•

reduce the double penalty nature of the provisions by removing the automatic debit to a company's franking account when a deemed dividend arises;

•

provide the Commissioner with an extended discretion in Division 7A to enable him to provide relief for deemed dividends that have arisen because of honest mistakes or inadvertent omissions by taxpayers; and

•

make a range of other mainly technical amendments to reduce the scope for normal business transactions to be inadvertently caught by Division 7A, when there has been no mischief intended and to generally increase its flexibility for taxpayers.

Proposed amendments

Removing the automatic debit to a company's franking account when a deemed dividend arises

1.87 The double penalty tax impost of Division 7A will be reduced by removing the automatic debiting of the company's franking account when a deemed dividend arises. This double penalty is unnecessary and not in proportion with the tax mischief of shareholders not declaring distributions from companies as assessable income. It also penalises all the company's shareholders, not just the shareholder assessed with a deemed dividend. Deemed dividends will, however, continue to be treated as assessable income in the hands of shareholders and associates.

1.88 This will reduce the harshness of Division 7A by taxing shareholders and associates only on the amounts received from the private company. The deterrent effect of the provisions will remain as deemed dividends will be subject to the marginal tax rate of the taxpayer without access to franking credits. This tax outcome still imposes a higher tax burden on genuine tax-avoidance arrangements.

1.89 Should the Commissioner exercise the discretion referred to below (to frank a deemed dividend) then the company's franking account would be debited.

Commissioner's discretion

1.90 The Commissioner's discretion in Division 7A will be extended. Currently Division 7A provides only a very limited discretion to the Commissioner to disregard its application in respect of loans, where he considers it reasonable in cases of undue hardship. The proposed amendments would provide a more general and flexible discretion to the Commissioner to enable him to provide relief for deemed dividends that have arisen under Division 7A because of an honest mistake or inadvertent omission. When considering the use of the discretion, the Commissioner would have regard to a range of factors including:

•

the circumstances that led to the mistake or omission which caused the deemed dividend to arise;

•

the extent to which the relevant taxpayer(s), (eg, the shareholder (or associate), or the private company) had acted to try to correct the mistake or omission, and if so how quickly that action was taken after the mistake or omission was identified; and

•

whether Division 7A had operated previously in respect of the relevant taxpayers, and if so, the circumstances in which this occurred (eg, if the Commissioner had previously exercised his power under this provision in relation to the entity that made the mistake or omission).

1.91 The Commissioner may exercise the discretion to disregard a deemed dividend or allow a deemed dividend that arises under Division 7A to be franked like other dividends.

1.92 The discretion has a retrospective element to enable the Commissioner to appropriately handle taxpayers with past mistakes or omissions; no tax mischief would have been intended in these circumstances. On this basis the Commissioner's discretion will allow him to extend time periods in relation to Division 7A. This has effect from the 2001-02 income year. If the Commissioner was satisfied that a breach of Division 7A requirements was inadvertent, he could use this discretion to extend the time available for taxpayers to rectify problems.

1.93 This discretion allows the Commissioner to appropriately handle cases that have not yet been identified through ATO audit activity. It would also allow those taxpayers that believe they may have inadvertently breached Division 7A to apply to the Commissioner for time to correct genuine errors.

Other mainly technical amendments

Allow payments to be converted to loans

1.94 Changes are made to allow 'payments' to be subsequently converted to a loan (between the company and the shareholder or associate) that can be fully repaid by the lodgment day of the private company's tax return for the year of income, or that meet the terms of section 109N (and thereby avoid the operation of Division 7A). Currently, some payments cannot be treated as loans that meet the terms of section 109N and as such trigger a deemed dividend. The change will reduce the inadvertent triggering of the provisions, increase the flexibility of the provisions by allowing taxpayers to put loans on a footing that meet the terms of section 109N and reduce compliance costs for taxpayers.

Deemed dividend to be the amount of the underpayment

1.95 If the minimum yearly repayments under a loan fall short of the required amount by the due date, the amount of the deemed dividend that arises will only be the amount of the underpayment in the income year, not the full amount of the outstanding loan, as is currently the case. This will have the effect of making the penalty consistent with the mischief committed by the taxpayer. It is inequitable to treat the whole loan as a deemed dividend, when for example, there was minor, unintentional underpayment. It is fairer for only the underpayment to be a deemed dividend in the relevant income year.

Allow refinancing of loans

1.96 Certain loans will be able to be refinanced without triggering a deemed dividend under Division 7A. This includes refinancing of loans between the company and the shareholder when the shareholder's loan with the company becomes subordinated to meet the requirements of a third party such as a bank; or where there is a change in the asset being used as security for the loan. To provide more flexibility for taxpayers and to prevent deemed dividends being triggered inadvertently, unsecured loans may be refinanced with a loan secured by a mortgage over real property and vice versa.

Relationship breakdown - allowing franked dividends

1.97 Transfers of property and payments in respect of marriage or relationship breakdowns are caught by Division 7A even though they may be non-voluntary (eg, by court order). However, while CGT roll-over relief will be available for transfers of CGT assets, income tax will be payable by the spouse (as a shareholder or associate) to the extent that there is a distributable surplus in the company (eg, undistributed after tax profits, or unrealised gains).

1.98 A deemed dividend that arises in these circumstances may be franked like other dividends the private company pays. This recognises that there is no attempt to make a disguised payment to a shareholder or associate for the purpose of tax-avoidance.

1.99 While these payments could be completely removed from being caught by Division 7A this would arguably be providing a tax benefit to these taxpayers which is not the intention of the provisions.

Discretion to extend time for minimim yearly repayments

1.100 The Commissioner will have a discretion to disregard a deemed dividend where the recipient of a private company loan (ie, the shareholder or an associate of the shareholder) was unable to make the minimum yearly repayments because of circumstances beyond their control. The Commissioner can specify a later time by which the minimum yearly repayments must be made. This will ensure that taxpayers will not be unduly penalised when they have made every effort to comply with the law but are unable to do so.

Allow for loan agreements to be made when interposed entities are involved

1.101 Division 7A does not allow loan agreements to be prepared between a private company and the target entity when interposed entities are involved. For example, Company A loans money to Company B and Company B pays that money to Company A's shareholder. At present this would be caught by Division 7A with no opportunity to put things on a commercial footing. Under this proposal, loan agreements that meet the Division 7A minimum interest rate and maximum term criteria in section 109N may be made between the interposed entity and the shareholder of the private company.

Remove the potential for double taxation in respect of guaranteed loans

1.102 Division 7A also applies to arrangements where a private company guarantees a loan made by a third party to a shareholder and the loan is in default. Division 7A will be amended to exempt guaranteed loans where the shareholder enters into a loan with the company that meets the requirements of section 109N (minimum interest rate and maximum term criteria). This will prevent the potential for both the guarantee and the loan to be deemed dividends - removing the potential for double taxation.

Calculation of distributable surplus (used to establish if a deemed dividend arises)

1.103 Section 109Y provides the basis for determining the company's distributable surplus which is used to determine the value of a deemed dividend under Division 7A. The distributable surplus depends in part on the value of the company's net assets (generally assets less the company's present legal obligations and certain provisions). Section 109Y also allows the Commissioner to substitute values where he considers that the company's accounting records significantly undervalue its assets or overvalue its provisions. There is no reason why this should not work both ways, for example assets may be overvalued in a company's accounting records because it has yet to undertake appropriate revaluations. Its provisions may also be understated. Therefore, the Commissioner's powers will be extended to allow him to also substitute values where he considers the company's accounting records significantly overvalue its assets or undervalue its provisions.

Payment of a set off dividend not taxable when a deemed dividend arises - technical correction to section 109ZC

1.104 Currently, section 109ZC is designed to prevent double taxation where a later dividend distributed by a private company can be offset against a dividend deemed to be previously paid by the company. The later dividend as an offset (to the extent that it is unfranked) is not assessable income up to the amount of the deemed dividend. However, instances of double taxation may arise if the borrower is not the shareholder of the company, but an associate. Changes will be made to Division 7A so that later dividends distributed may be applied by a shareholder as an offset against deemed dividends taken previously to be paid to the shareholder's associate.

Interaction between Division 7A and FBT

1.105 FBT may apply to an excluded loan, that is a loan (to a shareholder who is also an employee) that is made under a written agreement and meets the minimum interest rate and maximum term criteria of Division 7A. While Division 7A does not treat it as a deemed dividend, FBT may apply. FBT may also arise in subsequent years because of the different tax years for FBT (1 April to 31 March) and income tax (1 July to 30 June). If the FBT interest rate for employee loans is higher than the Division 7A benchmark interest rate, and the interest rate on the loan in question is lower than the FBT rate, a fringe benefit will arise.

1.106 It is proposed to exclude from FBT, loans that meet the criteria in Division 7A (relating to minimum interest rate, maximum loan term and loan documentation) in the year the loan is made. This also means that, in subsequent years, loans are excluded from FBT irrespective of whether the minimum interest rate requirement is met. This ensures that, if the Division 7A rate of interest is paid, no FBT liability arises.

Repeal section 108 of the ITAA 1936

1.107 Section 108 was the predecessor of Division 7A and likewise provides that if a private company makes a payment or loan out of profits to a shareholder or associate of the company then the amount may be deemed to be a dividend. It primarily applies to payments and loans made before 4 December 1997. If these are varied after that date, then Division 7A has application.

1.108 It is considered that after nearly 10 years of the operation of Division 7A and in light of the limited amendment periods for the ATO to adjust income tax returns (generally four years), section 108 no longer has any real application and, therefore, it is being repealed.

Time limit for making franking assessments

1.109 The time the Commissioner has to make franking assessments will be reduced to three years. At present it can be unlimited in some circumstances. A franking account return is taken to be a franking assessment under section 214-65 of the ITAA 1997. Under section 214-95, the Commissioner can amend a franking assessment at any time during the period of three years after the franking assessment was made. However, franking account returns are not required except in limited circumstances, for example, if there is a liability for franking deficit tax.

1.110 Where no franking account return is required (and therefore the Commissioner has not been taken to have made a franking assessment), the Commissioner will have only three years to issue a franking assessment reviewing the taxpayer's franking liability.

Assessment of impacts

Impact group identification

1.111 The proposals impact on taxpayers, that is, all private companies, and their shareholders and associates. This is considered to be a large number spread across micro, small, medium and large businesses across different industries. According to ATO taxation statistics for the 2003-04 income year, there were approximately 620,000 private companies in the tax system ^[3] . Private companies can have as few as one or two shareholders or a much larger number. Therefore there are a large number of individual taxpayers that could be affected by Division 7A. Tax agents will also be affected as they prepare returns on behalf of taxpayers.

1.112 It is not expected that the proposed changes will change the behaviour of taxpayers fundamentally. Private companies will continue to make loans to shareholders and associates on a commercial basis, but the knowledge that honest mistakes can be corrected should lead to taxpayers bringing these to the attention of their tax agents and the ATO.

1.113 The proposal will also impact upon the ATO.

Analysis of costs / benefits

Taxpayers and tax agents

Benefits

1.114 Overall, the proposed changes are beneficial to taxpayers and will be welcomed by taxpayers and tax practitioners. The proposals will reduce ongoing compliance costs for private companies when compared with the costs imposed under the existing provisions. This should lead to a reduction in planning effort (including tax agents' fees) and legislative complexity. However, the most significant benefit for taxpayers will be the reduced tax penalties.

1.115 A number of the changes will provide significant benefits through the reduced penalty tax impost.

1.116 For example, reducing the scope of the application of Division 7A will remove many of the 'inadvertent breaches' of the provisions, which were not meant to be captured. A number of the changes facilitate this, for example:

•

refinancing of loans when security changes (eg, mortgage);

•

allowing all 'payments' to be converted to loans and put on a commercial footing on terms that meet the minimum interest rate and maximum term criteria specified in section 109N of Division 7A;

•

allowing loans agreements between an interposed entity and the shareholder of a private company to qualify as a loan agreement between the private company and the shareholder; and

•

providing a franking credit on payments connected with marriage breakdowns recognising that this is not an attempt to avoid tax in these circumstances.

1.117 In addition, in the event that Division 7A is triggered, taxpayers will no longer have to suffer what is regarded as the 'double penalty' effect of Division 7A as the automatic debit to the company's franking account will be removed. When a deemed dividend is triggered the private company will still have access to its franking credits and therefore not all the shareholders of the private company will be penalised.

1.118 The Commissioner's new discretion will allow the operation of Division 7A to be disregarded in some circumstances (subject to conditions being complied with such as making the minimum yearly repayments on a loan), leading to potentially no penalty tax impost for taxpayers.

1.119 A number of the changes clarify the operation of the law and provide greater certainty for taxpayers, for example:

•

correcting possible double taxation involved with loan guarantees; and

•

where there is an underpayment of a loan repayment, the amount of the underpayment will be the value of the deemed dividend, not the balance of the oustanding loan - this is more equitable for taxpayers.

1.120 While private companies will still be required to self-assess if a deemed dividend arises, the number of tax calculations in respect of franking accounts will be reduced where a deemed dividend arises. For example, at present when a private company establishes that a deemed dividend arises, it is required to make an adjustment to its franking account and advise the shareholder or the associate of the amount of the deemed dividend with no franking credits attached. Under the proposed changes, this will occur less and when it does, the company will not be required to make adjustments to its franking account. Record keeping will therefore be simplified in respect of franking accounts in these circumstances.

1.121 Repealing section 108 removes uncertainty and confusion for taxpayers who currently still have to determine whether section 108 applies to each particular situation (eg, company to company loans which are specifically excluded from the application of Division 7A). In the event that the ATO identifies a transaction which may be considered a tax-avoidance arrangement, it may use the general anti-avoidance provisions (Part IVA of the ITAA 1936). Repealing section 108 will reduce compliance costs for taxpayers and their agents.

1.122 The changes to the FBT laws will provide that Division 7A 'excluded loans' are not fringe benefits. Employers will no longer need to calculate FBT on these loans because of this amendment.

Costs

1.123 There may be a small increase in transitional compliance costs for taxpayers and their agents as they will need to become familiar with the changes to Division 7A. The increase should be minimal as the proposals are changes to existing provisions within the tax laws and therefore, taxpayers and their tax agents should be familiar with the general concepts and framework to be applied.

1.124 Taxpayers will also incur compliance costs in understanding the extent to which the changes will benefit them, including consideration of whether to apply to the Commissioner to use his new discretion.

1.125 It needs to be recognised that at present taxpayers incur compliance costs in establishing whether they have met the requirements of Division 7A. When a breach is identified and it is a result of an unintended mistake or error, the taxpayer incurs costs in seeking to obtain relief from the ATO. Under the proposed changes, these costs are expected to be reduced as the ATO will now have more scope to address taxpayer requests for relief.

Australian Taxation Office

Benefits

1.126 The ATO will have more scope to deal with inadvertent technical breaches of Division 7A. At present the ATO has little scope to deal with a taxpayer's request for relief when an inadvertent breach has occurred through an honest mistake or omission. There will be more scope to settle disputes with taxpayers.

1.127 In the longer term, on an overall basis, the proposals should provide benefits to the ATO in terms of administration, as it will result in the ATO having to deal with fewer, largely technical breaches of the provisions.

1.128 Compliance activity may also be reduced as the ATO will not need to pursue transactions that would be breaches, but for these amendments.

Costs

1.129 The introduction of a general discretion will lead to an increase in administration costs for the ATO as taxpayers request the Commissioner to exercise his new discretion and deal with disputes if the discretion is not exercised. There will be some short term increase in workload and administration costs as the Commissioner develops products that give guidance on the factors the Commissioner will consider in exercising his new discretion.

1.130 The discretion will create an increased workload around receiving and processing requests for the Commissioner to exercise the discretion retrospectively and to process the subsequent amendments. Similarly there will also be a need for the Commissioner to develop a view and give guidance on the factors considered in exercising the retrospective discretion.

1.131 The ATO will also need to update publications and make taxpayers and tax practitioners aware of other changes. To this end, there will be minimal costs involved in drafting and issuing documents that assist with interpretation and which assist taxpayers to understand the tax system and law.

1.132 Initial estimates from the ATO indicate that the administrative impact would be between 1.1 to 5.9 full time equivalent (FTE) staff in respect of interpretation and information products and active compliance products. Based on a direct cost of around $100,000 per FTE, the cost would be between $104,000 and $560,000. This would likely be incurred in the short term - over the first 12 months.

1.133 The revenue impact of the changes is unquantifiable but is expected to be minor against the forward estimates. This is because there is some revenue that is being currently collected which is not from intended tax avoidance, but rather technical breaches of the provisions. This will now be forgone. It is also unknown exactly when the Commissioner would exercise his new discretion. On the assumption that the discretion would only be used where tax avoidance was not intended, revenue that was not expected to be collected will be forgone.

Consultation

1.134 These changes have been developed in consultation with major accounting groups (Institute of Chartered Accountants in Australia and the Taxation Institute of Australia) and some tax practitioners. These groups are supportive of the changes. These groups were also consulted on the draft legislation.

Conclusion and recommended option

1.135 The preferred approach is to make the changes outlined in option 2, rather than remove the self-assessment nature of the provisions and rely solely on ATO audit activity to identify breaches of Division 7A.

1.136 The current legislation is fundamentally sound and acts as a significant deterrent to tax avoidance. It encourages private companies to maintain proper financial and tax records for transactions between the company and its shareholders (and their associates).

1.137 The nature of the concerns identified with the operation of Division 7A can be remedied through a range of relatively minor amendments to provide more flexibility for taxpayers.

1.138 The proposed changes will increase taxpayer flexibility with respect to Division 7A and reduce compliance costs for taxpayers whilst maintaining integrity and assist the ATO in its administration of the provisions. These changes are beneficial for taxpayers.

1.139 The proposed amendments generally apply from the year commencing 1 July 2006. However, the Commissioner's new discretion would apply for the 2001-02 income year and later income years. This will enable him to deal with past breaches that may not have been identified by the ATO or taxpayers and that may warrant the use of his discretion.

1.140 The FBT changes are proposed to take effect from the FBT year commencing 1 April 2007.

1.141 Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an on going basis.