Division 7A De-fanged
Division 7A was originally introduced as an integrity measure
to prevent private companies from making tax-free distributions of
profits in the form of payments, loans and debt forgiveness to
their shareholders or associates. These rules were often described
as ‘draconian’ due to their disproportionate penalties and
rigid application.
Fortunately, successive legislative changes have taken the
pressure off tax agents and clients, particularly where they have
got it wrong. The most recent changes introduced through the Tax
Laws Amendment (2007 Measures No 3) Act 2007, will have the effect
of further reducing the pain of Division 7A by providing solutions
to most Division 7A problems.
Simple errors
Inadvertent errors and honest mistakes dating back to 1 July
2002 can now be fixed by requesting that the Commissioner exercise
discretion to disregard Div 7A deemed dividends (or to allow the
deemed dividend to be franked). However, it is recommended that
tax agents carefully review each disclosure (having regard to the
Commissioner’s criteria) before making a request.
Less to lose
Currently, under section 109E of the ITAA 1936, where a
shareholder makes a repayment, which is less than the ‘minimum
yearly repayment’ of an amalgamated loan, there is a deemed
dividend (even if the shortfall was nominal due to an innocent
miscalculation). The ‘minimum yearly repayment’ amount is
based on the current year’s benchmark interest rate.
The application of section 109E remains the same after the new
amendments; however the amount of the deemed dividend has changed.
Under the previous section 109E, the quantum of the deemed
dividend was the outstanding balance of the loan.
Under the new section 109E, the amount of the deemed dividend
is the shortfall between the amount paid by the shareholder and
the ‘minimum yearly repayment’ of the amalgamated loan.
Example
HIJ 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 previous law, a deemed dividend would therefore arise
equal to the outstanding balance of the loan, which is $88,000
(i.e. principal of $100,000 + interest of $7,000 – payments of
$19,000).
Under the new law, a deemed dividend would still arise, but the
amount of the dividend will equal the shortfall, which is $1,000
(i.e. $20,000 – $19,000).
The changes mean that the deemed dividend amount will be
significantly reduced in almost all circumstances. As demonstrated
from the example, the difference in the deemed dividend amount can
be quite substantial.
Other positive outcomes
A further outcome from the changes to Division 7A is the
removal of the automatic debiting of a private company’s
franking account where there is a deemed dividend.
Continuing with the above example, under the previous law, HIJ
Pty Ltd would be required to debit $37,714 (ie $88,000 x 3/7) in
its franking account.
Under the new law, HIJ Pty Ltd will no longer be required to
debit the franking account.
Time to pay
Shareholders that ‘took the money’ from the company also
have the ability to fix the situation, by declaring a dividend
prior to lodgment of the tax return in the year following the year
they ‘took the money’.
Example
In November 2005, Fred used the company chequebook to buy a new
Audi TT worth $80,000. The accountant’s reaction was to pay a
dividend on 30 June 2006. But he did not have to pay a dividend at
30 June. Fred also does not need to have a loan agreement in
place.
Instead the accountant should have advised Fred’s company to
declare a dividend of $80,000 before the earlier of the due date
or lodgment date of the company’s tax return (i.e. this could
have been done as early as 1 July 2006 or as late as March 2007 in
year 2).
That way the company has complied with Division 7A in the 2006
year (i.e. Year 1) and there is no tax payable on the dividend in
that year. The assessability of the dividend has effectively been
deferred from the 2006 to the 2007 year. Furthermore, tax on the
dividend will not be payable until the 2007 tax return is lodged
and assessed which could be as late as the last quarter of 2008
(i.e. Year 3).
This is article appeared in Thomson’s InTax
magazine (August 2007); Australia’s best independent monthly tax
magazine. It provides concise reports of the latest tax news, plus
the practical implications of tax developments in an easy-to-read
magazine format. To find out more, phone Thomson Customer Service
on 1300 304 197.
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